The Opportunity Cost Principle

All important decisions or choices involve a trade off. Thus, any explanation of why somebody chooses one thing must consider the alternative(s) that could have been chosen but were not. Often, opportunity cost in a market economy can often be summarized accurately by using relative prices: if the price of an apple is $2 and the price of an orange is $1 then the opportunity cost of one more apple is two less oranges. These ideas are mentioned so often in economics classes that the only thing which some former economics students remember is opportunity cost. This principle offers deeper insights also.

Some apparent paradoxes in decision-making can be resolved by noting that something about the situation creates a difference between financial cost and opportunity cost. Thinking carefully about opportunity cost also reveals that studying economics is not all about money and financial metrics. The study of economics is about people and behaviour.

Examples: Good and bad

Economics textbooks offer many examples of the concept of opportunity cost, in addition to the traditional and boring example that a country must choose between guns and butter https://en.wikipedia.org/wiki/Guns_versus_butter_model . Other examples can be encoded in language, such as 

• “Trade-offs are essential to strategy. They create the need for choice and purposefully limit what a company offers.” (Michael Porter, “What is Strategy”, Harvard Business Review, Nov./Dec. 1996, https://hbr.org/1996/11/what-is-strategy). This idea leads to a discussion of competitive advantage, which is essential to understanding why some businesses excel and others do not.
• Government regulations are often intended to change people’s decisions: it adds a constraint and changes market prices. For this reason, analysing the costs and benefits of that change needs to look beyond financial prices. Thus, the alternative to the current policy is not what you may think.
• Opposition politicians often criticize a government policy, without mentioning a clear alternative. They avoid pointing out the opportunity cost: the preferred political statement seems to be “Their policy is bad” instead of “My policy is better because …”.

This style of arguing is not restricted to politics. In companies with bad corporate cultures, people engage in unconstructive arguments: ideas are attacked (or, worse, the person proposing the idea is attacked) without considering the merits, alternatives or ways to tweak the idea to make it more effective.

• “Perfection is the enemy of the good”: For important problems, it is often hard to find a good solution. It is harder to propose that solution if you expect somebody to criticize it by saying something like “Yes, it is a good alternative but, in an ideal world, the better solution would be to …”. This criticism is often misplaced because, in the real ideal world, there would be no costs and everybody would be working together to achieve the goal. When using a decision perspective, a wise choice accounts for all of the relevant costs (financial and otherwise). When judging what is a good (and feasible) solution from a broader perspective, two other principles (gains from trade and equilibrium) are more instructive.

Cheat codes in a computer game make the game boring, unless there is a price to pay. A computer game would be extremely boring if every player could choose to be invincible without cost. (Unfortunately, since people do not like to exert effort if there is a preferred alternative, the opportunity cost may not be what the game-designers expect. Market forces may create a different way (i.e., an “alternative”) to obtain that prize.)  https://en.wikipedia.org/wiki/Virtual_economy#Black_market https://en.wikipedia.org/wiki/Cheating_in_online_games#Unsporting_play

This perspective may also explain why decades of storytelling has relied on Superman being vulnerable to kryptonite and to magic. If invincibility were the result of previous efforts then the player faces an opportunity cost when deciding how much exert to effort.

The concept of opportunity cost is not always easy to grasp. Some people, including otherwise-careful economists, may confuse “opportunity cost” with “the value of the alternative”. When analysing a choice, they may focus on financial metrics such as price or the return on investment. In my opinion, the opportunity cost of choosing X is a feasible alternative. The value of any alternative can be measured in many different ways and that value often varies according to a person’s tastes. This statement may illustrate the benefits of separating the concept of opportunity cost from the concept of taste.

Related Ideas

The role of incentives is linked to opportunity cost. For example, it is obvious that an increase in the price of apples causes people to buy substitutes (e.g., oranges or apple juice or ???). As a matter of careful thought, those alternatives existed before the price increased. For example, since the alternatives were not chosen before, what does that fact reveal about the context?

A focus on relative prices as a summary measure of opportunity cost is instructive, because some changes in a situation affect both prices. For example, general inflation increases the price of both apples and oranges. A simplistic argument would say that “an increase in the price of apples increases the quantity demanded of oranges”. The simplistic argument is seductive because it is not wrong and, without general inflation, would be correct. People create trouble for themselves when they fail to recognize that the argument is incomplete.

The opportunity cost principle reminds individuals that decisions involve things that they can control. Or, in more practical terms, the cost of a decision already exists and the only real choice is the form or appearance of that cost.

Statements from economists are often seen as depressing or as bad news. The opportunity cost principle fits this perception. It is more accurate to say that much of an economist’s time is spent reminding people to think clearly. People may not like the idea of opportunity cost but the alternative to “there is no free lunch” is “there is no alternative”.

Now, it is your turn to write.

1. Sometimes, opportunity cost can be measured in financial terms, at least as a useful start. Consider government spending. You probably have a government expenditure that you think is stupid and an alternative that you think should be expanded. So, if the scale of stupid expenditure were cut in half, how much would your preferred program expand by? Since the relevant answer is not a dollar figure but something real, it may help if your preferred expenditure were easily scalable or divisible. Then you could write “Cutting X by half could result in 10 more basketball courts in city parks”.
2. Can you think of any situations where there is an interesting difference between opportunity cost and financial cost? In those situations, what factors would increase or decrease that difference?