‘Opportunity cost’ is one of the most fundamental concepts in economics. When choices have to be made, the opportunity cost of the preferred choice is measured by the net benefits that could have been secured by choosing the best of the rejected alternatives.
The concept is straightforward common sense; applying it is the tricky bit.
Imagine you won a free ticket (which has no resale value) to see an Eric Clapton concert. Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan.
Would the opportunity cost of going to the Clapton concert be $0, $10, $40 or $50?
This question was posed in an article: Do Economists Recognise an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science, by Paul J Ferraro and Laura O Taylor. In a survey of approximately 200 economics graduates – many of them with PhDs – only 21.6 per cent gave the correct answer. Of the economists who answered incorrectly, their responses were almost evenly distributed between the three wrong answers.
The correct answer, by the way, is $10, being the benefit of $50 less the ticket cost of $40. If you are embarrassed, you are in good company.
Put most simply, a forgone net benefit (eg of $10) represents the opportunity cost of the preferred choice, and a forgone net cost is a benefit.
Opportunity cost is fundamental to cost-benefit analysis. If the net benefit from the preferred course of action does not exceed its opportunity cost, why is it the preferred course of action?
In their article, Ferraro and Taylor also asked what the minimum net benefit from listening to Clapton would have to be to justify forgoing listening to Dylan. That’s right, the answer is $10. If it were $5, the opportunity cost of listening to Dylan would be $5, half the $10 benefit.
People understand these things intuitively in their private lives, but when they vote in general elections they might hope to secure a benefit at someone else’s expense. This incentivises political parties to stress the benefits from ’free’ this or that, neglecting opportunity cost. Yet a dollar spent on, say, education is a dollar less spent on something else.
When choices have to be made, there is no free lunch; there is only opportunity cost.
Loosely coinciding with this year’s election campaign, Insights is campaigning for economic literacy from A to Z. Coming up next week: ‘P’ for Price.