first step to making good decisions is to think about the
trade-offs involved. This
primer explains how measuring opportunity cost can help you find
the trade-off that lurks within every decision.
Let's begin by analyzing a
typical decision carefully, just as a coach might videotape a
tennis player's stroke and then study it frame by frame.
Suppose that Jim is about to purchase a CD of
his favorite singer. Let's
see what goes on in his mind as he makes his decision.
Jim first looks at the
songs and thinks about the hours of pleasure he would get
listening to them. In
economic terms, he determines the benefit
he expects to get from the CD.
Next, he glances at the price tag to see how much it costs
-- $15. Jim determines that the CD's benefit exceeds its cost, so he decides
to buy it.
To make his decision,
Jim followed a simple rule: Do
something if its benefit outweighs its cost.
To see if Jim's rule is a good one, let's try it out on
another problem. Suppose
a woman is walking along down the street when she sees a dime on
the sidewalk. Should
she pick it up?
you may be thinking. If
she picks up the dime, she gets a benefit of 10 cents.
On the other hand, it doesn't cost her anything to pick it
up. The benefit
clearly outweighs the cost.
if the woman is Madonna, and she's hurrying to a recording studio
where a symphony orchestra is waiting to perform with her.
Do you still think she should stop and pick up the dime?
worth her time. Perhaps
Jim's rule needs to be modified, say to this:
Do something if its benefit outweighs its cost unless
you're a famous singer. Or
a movie star, or President of the United States, or a
there's a simpler way. We
can greatly improve Jim's decision-making rule by adding just one
word. Here's the rule
for deciding whether it's in your own best interest to do
something if its benefit outweighs its opportunity cost.
When asked how much something costs, people usually answer by
giving its price, or money cost. Economists
usually measure cost differently, using what they call opportunity
cost, defined as the
value of the next best alternative opportunity that is given up in
order to do something.
Here's how to calculate it.
When considering a choice, ask yourself three questions:
What alternative opportunities are there?
2. Which is the best
of these alternative opportunities?
3. What would I gain
if I selected my best alternative opportunity instead of the
choice I'm considering?
The answer to the third question is the opportunity cost of the
To find out the opportunity cost to
Madonna of picking up the dime, we need to come up with her
alternative opportunities and select the best one.
Let's assume that Madonna's best alternative to picking up
the dime would be to leave it on the sidewalk and arrive at the
recording studio 30 seconds sooner.
The value of those 30 extra seconds at
the recording studio is the opportunity cost to her of picking up
the dime. She should
compare the benefit she'd get from picking up the dime (10 cents)
with its opportunity cost (arriving 30 seconds sooner at the
recording studio) to decide what to do.
When we compare the opportunity cost of picking up the dime
with the benefit, we can see that it doesn't make sense for
Madonna to retrieve it. Her
time would be better spent at the recording studio.
Perhaps a child─whose time isn't worth as
much─will come along later and decide to pick up the dime.
cost and trade-offs
Let's have Jim decide again whether to buy the CD, this
time using opportunity cost instead of money cost.
As before, he should first consider the benefit he'd get
from the CD, and look at its price tag.
But before making a decision, Jim should consider
alternative opportunities -- other things that he could do
with the $15. Suppose
his best alternative is to buy a pair of $15 sunglasses.
The value to him of the sunglasses represents the
opportunity cost of the CD.
As he decides whether to buy the CD, he should compare its
benefit with its opportunity cost -- the sunglasses.
If the benefit (the value to Jim of the CD) outweighs the
opportunity cost (the value to Jim of the sunglasses), then he
should buy the CD. If
the benefit is less than the opportunity cost, then he shouldn't
In other words, thinking about the opportunity cost of
buying a CD expresses the problem as a choice between the CD and
the sunglasses. This
is precisely why opportunity cost is such a powerful
decision-making tool. It
shows a decision for what it really is -- a trade-off between
your two best alternatives.
As another example, consider a government proposal to build
a new dam. Here's how
a poor decision-maker might view the problem:
"If we build a dam, we'll have better flood control
and cheaper electricity. If
we don't, then we'll experience occasional flooding, and
electricity will be more expensive."
Here the choice seems to be between having a dam and not having a
dam. When put that
way, it's tempting to choose to build the dam.
Cheaper electricity and flood control are better than
expensive electricity and floods.
Here's another way of presenting the problem:
"If we build the dam, it will provide us with flood
control and cheaper electricity, but it will cost us $100
This decision-maker recognizes that something must be given up to
build a dam. There's a
trade-off. This is
better, but still not the best way to view a decision. When
we think of the cost in dollars, the trade-off we're facing is
often unclear. It's
hard for most people to imagine how much $100 million is, and we
don't know whether the money could be put to better use elsewhere.
Here's how an economist would view the problem:
"If we build the dam, we'll have flood control and
cheaper electricity. But
the $100 million to build the dam could be used instead to
build two new high schools."
Here, the benefit of the dam is compared with its opportunity
cost: new high
that way, the cost of the dam becomes much more concrete.
Besides, it's not really money that we're sacrificing when
we build a dam, but rather resources -- workers, machines,
cement, and land -- that could be used elsewhere.
If money were the only thing we sacrificed, there would be
no trade-offs; our government could buy us everything we
wanted simply by printing more money, preferably in very large
opportunity cost -- an example
Ernesto is trying to decide whether to attend
college and has determined the money cost of attending college for
Cost of a Year of College
Books and school supplies:
Room and board: 10,000
Miscellaneous expenses: 3,000
Ernesto how much money he'll need to come up with if he decides to
go to college.
But in order to decide whether to go to college,
Ernesto should figure out its opportunity cost.
The first step is for Ernesto to determine the best
alternative to going to college.
Let's say that it's working full time at the local
opportunity cost of going to college, then, is the value of what
he would gain if he worked instead of going to college.
If Ernesto worked, he wouldn’t have to pay for tuition,
books, or school supplies. He
also would earn $10,000 during the year that she worked.
The opportunity cost of a year of college, therefore, is:
Cost of a Year of College
Books and school supplies:
Foregone wages from working: 10,000
tells Ernesto how much he'd have to spend on other
things if he decided not to go to college.
You may be wondering why we didn't include room and board,
transportation, entertainment, and miscellaneous expenses in the
opportunity cost calculation.
Wouldn't Ernesto have these expenses at college?
Yes, he would, but he also would face these costs if he
decided to work. Remember,
opportunity cost includes only the value of what one would gain
under the next best alternative opportunity.
Ernesto can't get out of paying for room and board,
transportation, and entertainment by working.
These expenses, therefore, should not be included in the
opportunity cost of going to college.
The opportunity cost of going to college -- $13,000 -- tells Ernesto what he would gain if he chose not to go to
college. When deciding whether to go to college, he should weigh
that cost against the benefits of college, like higher future
earnings, new friends, and a better understanding of our world.
as Eskimos have lots of words to describe snow, economists have
lots of words to describe cost.
This section introduces sunk costs.
are costs that must be paid whether or not you do something.
They're of special interest to us because we don't
want to include them when calculating opportunity cost.
Unfortunately, sunk costs are like invasive weeds; it's
often hard to yank them out of a problem.
To see why sunk costs should be ignored, let's go back to Sheila,
who has had her car for a week now.
She has just returned home from school and she's trying to
decide whether to go out and see a movie.
figure out the opportunity cost of seeing a movie, Sheila first
determines her best alternative opportunity.
Let's assume that it's to stay home and do homework.
Next, she lists all the things that she would gain if she
stayed home and did homework instead of watching a movie.
Cost of Going
to a Movie
to do homework:
Gas and parking:
Admission to the theater:
3 hours and $3.50
that Sheila correctly includes gas and parking in her opportunity
cost calculations. But
what about all the other costs associated with owning a car, like
insurance and registration fees?
Shouldn't she include them as part of the opportunity cost
of going to a movie?
The answer is no. If
Sheila stayed home, she'd still have to pay the same insurance and
registration fees. She
can't reduce these costs by staying home.
Insurance and registration fees are examples of sunk costs.
Sunk costs can't be recovered by choosing the best
alternative opportunity. That's
why economists use the following rule when calculating the
opportunity cost of something:
Now suppose that Sheila decides to go to the movie and her little
brother asks to come along. He
will pay for his own admission.
What is the opportunity cost to Sheila of bringing him?
The answer is nothing at all.
Since Sheila has already decided to go to the movie
theater, the expense of driving there has become a sunk cost --
she will incur that expense whether or not her brother comes.
She doesn't sacrifice anything by bringing him along,
unless, of course, he's obnoxious.
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