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Economics Notes

Opportunity Cost

Opportunity cost is one of the most important and fundamental concepts in the whole of economics. Given that we have said that economics could be described as a science of choice, we have to look at what sacrifices we make when we have to make a choice. That is what opportunity cost is all about.

The definition of opportunity cost is:

The language used here is a bit technical but it expresses a very easy but often misunderstood principle. We need to unpick the definition to help get the understanding right. Cost implies something is being sacrificed or involves having to give up something. We often use the term 'cost' in the wrong way. How many times have you used 'cost' when you mean 'price'? Take the following example:

The cost here is being expressed in terms of the amount of money you had to give up to acquire those shoes. Because we all have a common understanding of 'money' as being notes and coins that we use to exchange for the things we want, we can pretty much understand this sentence.

We have to remember that money is merely bits of paper or metal that we use as a convenient and accepted method of facilitating exchange - getting what we want. Expressing 'cost' in terms of the amount of money we have to give up to get what we want is always helpful in giving us the true 'cost' of something. For that, we need to use 'opportunity cost'. Copyright: Daniel Wildman, from stock.xchng.

What statements like this fail to convey, however, is the true picture of what you are sacrificing by choosing to buy the shoes. It is more accurate to say something like 'the price I paid for these shoes was £40.' To get an idea of the true 'cost', we would really need to know something of the sacrifice made in giving up that £40.

Shoes - Price, £40. What am I sacrificing to acquire these? Copyright: Lotus Head, from stock.xcng.

£40 can buy a number of things - let us assume that it can also buy the following:

	Three CDs. Copyright: Kay Garston, from stock.xchng.
	A new sweater. Copyright: Jean Scheijen, from stock.xchng.
	A meal out for three. Copyright: Doru Lupeanu, from stock.xchng.
	A return flight from London Gatwick to Madrid. Image copyright: Dieghh D, from stock.xchng.

When thinking about how to dispose of your money, you have to make choices and these represent the choices at this moment in time. These choices represent different aspects of value. Each of the items might represent some value to you but they may be different. It is important to remember that you might, in an ideal world where there were no scarce resources, want all these things.

It might be possible to order the value of each of these items. The value score is given out of 10 but it could be 100, 1,000 - anything!

Having gone through the mental process of attaching a value to your choices, it is clear that there is only one choice to make - the shoes. In buying the shoes you have had to sacrifice the opportunity to purchase one of the other items in your choices list. What is the next best alternative foregone? It will be the item that gives the next highest value - the 3 CDs in this example.

The cost of the shoes, therefore, is better expressed as the 3 CDs sacrificed. We can assume from your decision that you value the benefit or satisfaction (economists call this utility) you will gain from the shoes at this point in time higher than the value you place on the CDs. This is assuming that humans behave rationally and would not give up their scarce resources (money in this example) on something when another item could be acquired that gives a greater degree of satisfaction. That assumption of rational behaviour may not necessarily hold in reality!

Looking at cost in this way enables us to make some interesting insights into the behaviour of individuals, international institutions, the government and businesses, and helps us to comprehend decision-making at all levels.

Let us use some examples to illustrate this.

A leading charity is working in a country that has been hit by a severe earthquake. It knows that there are a wide range of competing needs of the population in the area: food; clothing; shelter; medicine; counselling; education; clearing up, and reconstruction of houses and amenities. It only has a limited amount of funds, far less than would be required to satisfy all these requirements. It has to make some tough choices but tries to rationalise those choices by placing a value on the importance in terms of the benefits to the widest number of people from the allocation of its scarce resources (in other words, spending its money).

Image copyright: Demnetti, from stock.xchng.

It decides to focus on the erection of tents and provision of medicine as its main priorities. The monetary cost of this decision might be £15 million but the opportunity cost would be expressed as the food that is not being provided for the displaced population, or the clothing, reconstruction and clearance that would have to be sacrificed.

The government has been conducting a public inquiry into the construction of a road that will act as a by-pass around a very busy market town. The inquiry has heard from many different sections of the local community and individuals and groups nationally on the proposal. One of the main objections to the new road is the potential impact on a Site of Special Scientific Interest (SSSI). The new road would run through wetlands bordering a local river where a wide range of different creatures live. Opponents have pointed out that the damage to the ecology of the area cannot have a value placed on it.

Getting rid of traffic jams - worth more than a site of special scientific interest? Copyright: Fira Anuar, from stock.xchng.

Other contributions to the debate have suggested that the £1.6 billion monetary cost of constructing the road ought to be used to provide better public transport and get cars off the road rather than encourage more cars. Still others have bemoaned the poor quality of the local schools and want the money used there whilst others have suggested that spending it on local health services would be a more useful use of the money.

The government decide to go ahead with the road construction and cite the value of the benefits to be gained for local people, the town and the wider community as being of primary importance. The opportunity cost therefore is the damage to the local ecology or the investment in public transport, education and health services that have had to be sacrificed.

Opportunity cost, therefore, is a really important concept to grasp. It is not something that you can cover in one lesson and then forget about. It has relevance to almost every decision that is made in every economy on the planet. You should seek to try and grasp its relevance at every possible stage in your studies.

A real understanding of this concept will help you to think like an economist - something that we should all be aiming for in the study of the subject.

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