Opportunity Cost

Opportunity cost is a term used in economics, to mean the cost of something in terms of an opportunity foregone. For example, if a city decides to build a hospital on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land instead. In building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, and so on.

The concept of opportunity cost is widely recognized as one of the very few profound "eternal truths of economics" (1). A classic illustration of the concept envisions an imaginary economy capable of producing only two products: "guns and butter." If all the resources of this economy were used to produce guns, let's imagine that 100,000 guns could be produced. If, instead, all the resources were used to produce butter, let's imagine that 100,000,000 units of butter could be produced.

So, should this economy's resources be used in practice to produce 50,000,000 units of butter, there will be an opportunity cost in terms of guns. Instead of the 100,000 guns the economy could have produced, it may now only be able to produce 50,000. Conversely, should this economy's resources be used in practice to produce 75,000 guns, there will be an opportunity cost in terms of butter. Instead of the 100,000,000 units of butter the economy could have produced, it may now only be able to produce 20,000,000.

The graph that depicts opportunity cost between any two given items produced by a given economy is known in economics as the products possibility frontier. The line describing this frontier is not straight, but is curved inward toward the axises to reflect the higher marginal costs that become inevitable due to increasing productivity inefficiencies at the extremes. The point on the graph that describes the two given items' position will always lie somewhere well within the frontier, due to the rescources used by all the other products and services that the given economy produces.

The simplest way to estimate the opportunity cost of any single economic decision is to consider, "What is the next best alternative choice that could be made?" (Even though most economic decisions involve multiple alternatives.) The opportunity cost of paying for college this semester could be the ability to make car payments. The opportunity cost of a vacation in the Bahamas could be the downpayment money for a house. The opportunity cost of the USA's Space Shuttle program could be the launching of more numerous unmanned probes. The opportunity cost of a welfare programs could be funds for education or defense.

Note that opportunity cost is not the sum of the available alternatives, but rather of any particular one of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate.

It is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action. However, some opportunities may be difficult to compare along all relevant dimensions.

Economists often try to use the market price of each alternative. This method, however, presents a considerable difficulty, since many alternatives do not have a market price. It is very difficult to agree on a way to place a dollar value on a wide variety of intangible assets. How does one calculate the cost in dollars, pounds, or yen for the loss of clean air, or the loss of seaside views, or the loss of pedestrian access to a shopping center, or the loss of an untouched virgin forest? Since their costs are difficult to quantify, intangible values associated with opportunity cost are easily overlooked or ignored.

To overcome this difficulty, economists have identified certain opportunity costs as spillover costs. If a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish. If a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the company's advertisers.

Typically, spillover costs are imposed by a narrower group (often called a special interest group) which benefits more quanifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely. For this reason, spillover costs are most often controlled by politics and government regulation rather than by markets. Regulations against pollution and building codes restricting billboard locations are examples.

Special interest groups, with a particular political or financial gain in mind, usually find incentives to underestimate or ignore the opportunity costs associated with their activities or agendas (especially when the opportunity costs are spillover costs, that can be imposed upon others), but at times such groups find incentives to overestimate them.

Another difficulty in fixing opportunity cost exists on the macroeconomic level, and is empirical in nature. Discovering the real effect of a change in production of butter specific to the production of guns in an economy as large and multifarious as, say, that of the United States, would be nightmarishly complex.

For that reason, opportunity cost is usually figured within some specific budget of resources. For example, "If the state spends $200 million more on highways it will have $200 million less to spend on schools." Or, "If our company invests $10 million in R+D, it can't give a $1 million Christmas bonus to each of its top ten executives." Or, "If I buy fifty lottery tickets, I won't have these two twenties and one ten left in my wallet for groceries."

Although opportunity cost can be hard to quantify, its effect is universal and very real. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones. (The word "decide" comes from the Latin decidere, meaning "to cut off"; being the prefix de plus the root caedere, "to cut"). By definition, any decision that is made cuts off other decisions that could have been made. If one makes a right turn at an intersection, she or he precludes the possibility of having made a left turn. Etc.

Opportunity cost is the hidden cost of any and every economic decision. Ignoring opportunity cost can make certain economic decisions appear to have no cost at all, and can produce fallacies such as the broken window fallacy described by Frederic Bastiat.

Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

See also:

• Neoclassical Revolution