Overview
Because resources are scarce, choosing one thing means giving up another. Economists call the value of what is given up the opportunity cost. Friedrich von Wieser of the Austrian school developed, in Der natürliche Werth (1889), the idea that the cost of a productive resource is the utility of the other goods it could have produced. The American economist David I. Green, in "Pain-cost and opportunity-cost" (1894), argued that the cost of production is the sacrifice of forgone opportunities rather than physical pain, introducing the term to English-language economics.
Definition and calculation
Opportunity cost is not the sum of all forgone alternatives but the value of the single best alternative given up. Taking university study as an example:
- Explicit costs: money actually paid, such as tuition and books.
- Implicit costs: value given up without a cash outlay, such as the income one could have earned by working instead.
Costs that would be incurred anyway, such as food and housing, are not part of the opportunity cost. For a firm, accounting profit subtracts only explicit costs from revenue, while economic profit also subtracts the opportunity cost of the owner's capital and labour. Zero economic profit means the firm earns a normal profit.
Distinction from sunk cost
A sunk cost has already been incurred and cannot be recovered whatever one decides. Rational choices compare only future benefits and opportunity costs, so sunk costs should be ignored. People nonetheless tend to persist with losing choices because of money already spent (the sunk cost fallacy), a central topic in behavioural economics.
Production possibilities and comparative advantage
The production possibility frontier shows the maximum combinations of two goods that given resources can produce. On the frontier, producing more of one good requires producing less of the other, and that reduction is the opportunity cost. A frontier bowed out from the origin indicates increasing opportunity cost. Ricardo's comparative advantage is also defined by opportunity cost: a country whose opportunity cost of producing a good is relatively lower has a comparative advantage in it.
Applications and debates
- Valuing housework: the opportunity-cost method values unpaid housework at the wage the person could have earned in the market; it is used alongside the replacement-cost method, which uses the price of hiring someone else.
- Fertility: the income women forgo while raising children is one strand of theories of low fertility.
- Subjective cost: James Buchanan (1969) stressed that opportunity cost is the chooser's own subjective valuation and cannot be measured precisely by an outside observer.
- Opportunity cost neglect: Frederick et al. (2009) found that consumers often fail to think spontaneously of what else they could do with their money, and that reminding them of alternatives reduces purchases.
References
- Wieser, F. von (1889). Der natürliche Werth. Wien: Alfred Hölder.
- Green, D. I. (1894). Pain-cost and opportunity-cost. Quarterly Journal of Economics, 8(2), 218–229.
- Buchanan, J. M. (1969). Cost and Choice: An Inquiry in Economic Theory. Chicago: Markham.
- Frederick, S., Novemsky, N., Wang, J., Dhar, R., & Nowlis, S. (2009). Opportunity cost neglect. Journal of Consumer Research, 36(4), 553–561.