Opportunity Costs

by Will Wilkinson on November 10, 2004

Don Lloyd at Catallarchy posts what he calls an “Opportunity Cost Puzzle.” What I find puzzling is that so many of the other commenters find it puzzling. I always thought that the opportunity cost of an action is the utility you would have gained from choosing the alternative ranked #2 in your preference ordering. It’s what you would have gotten if you would have done the next most preferred thing. If that’s right, then the answer to Don’s puzzle is easy. My answer is in the Catallarchy comments. (Scroll way down.) Am I right? Is most everybody else confused? Or am I just being philosophically willful in refusing to think of the problem in money terms?

Kenny Easwaran

I think you're right about the fact that buying the TV had an opportunity cost of (whatever it is he would do with) $2000, but once he's bought it, the opportunity cost of keeping it is $3000, rather than $1000 (what he could have gotten from selling it) (or whatever else it is he might have done with a TV). Keeping the TV doesn't undo the $2000 purchase.

I think the confusion is that people equivocate between opportunity cost as what the benefit of the second-best option would have been, versus the difference in benefit between the chosen option and the next best option. In addition, there are two clear choices for second-best option. The $1000 comes from differences, the $2000 from the choice of not having bought it, and the $3000 from the choice of buying it but not having sold it.

Glen

Will -- you're correct. However, as shorthand, we economists often like to be able to specify opportunity cost in dollar terms, so we can say "$2000" instead of "whatever you would have done with $2000."

Also, if you want to get really philosophical, ask yourself if it makes sense to speak of the utility of the forgone option if there is only ordinal (not cardinal) utility. If I choose option A over option B, an ordinal utility approach simply says that I (presumably) prefer A to B, but it doesn't attach any absolute value to either one. So what does it mean to talk about the utility of the forgone option B? (I think there's a reasonable answer to this question, but it requires being more careful with language than we usually are.)

David Rossie

I over-analyzed the question, but my interpretation of opportunity cost is cost plus forgone income. So, utility you would have gained from the second-best use, AND the explicit cost.