Opportunity Cost
James R. Freeland
Opportunity cost exists whenever choosing one alternative precludes the choice of another alter native in a world of scarcity. It is an important principle of rational decision theory. It arises when some alternatives are not formally considered in a rational analysis.
For example, suppose a person is faced with the choice of whether or not to play a colleague in handball for an hour. In making a rational choice, if this person made the choice by considering only the value (utility) received from playing handball, the analysis would be incomplete because the opportunity cost of the next best alternative (perhaps working on a revision of a book) was not considered. In making the choice of whether to play handball, one must consider the cost of the lost opportunity (working on the book revision).
Samuelson and Nordhaus define opportunity cost in the following way: ‘‘The value of the next best use for an economic good, or the value of the sacrificed alternative. Thus, say that the best alternative use of the inputs employed to mine a ton of coal was to grow 10 bushels of wheat. The opportunity cost of a ton of coal is thus the 10 bushels of wheat that could have been produced but were not’’ (Samuelson and Nordhaus, 1992: 743). The idea of ‘‘best alternative’’ recognizes there may be many alternative uses of a resource, but that the opportunity cost is deter mined by the most valuable benefits sacrificed. This implies that the correct opportunity cost can only be determined by considering the specific details of a specific problem situation.
The concept of opportunity cost serves to remind us that the out of pocket dollar outlays are not a complete measure of the cost. The concept is sometimes misapplied and misunderstood in practice because of the practical difficulty of determining the value of the next best alternative. As an example, consider the cost of getting an MBA degree. The out of pocket costs for tuition, fees, books, and room and board might total $60,000. However, the true cost of getting the MBA degree must also consider the cost of the next best alternative (e.g., working as a financial analyst). Suppose one could earn $40,000 by working as a financial analyst during the same amount of time it takes to get the MBA degree. Then the true cost of getting the MBA is actually $100,000. One way to avoid having to consider the opportunity cost in this way is to formally consider the choice between two alter natives: (1) get an MBA degree, or (2) work as a financial analyst. The cost of (1) is $60,000. This should be compared to the cost of (2), which is the most valuable benefit sacrificed.
Bibliography
Heymann, H. G. and Bloom, R. (1992). Opportunity Cost in Finance and Accounting. New York: Quorum Books.
Samuelson, P. A. and Nordhaus, W. D. (1992). Economics, 14th edn. New York: McGraw-Hill.