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ECONOMIC SCENE
The Opportunity Cost of Economics Education
By ROBERT H. FRANK
Published: September 1, 2005
SHORTLY after I began teaching, more than 30 years ago, three friends in different
cities independently sent me the same New Yorker cartoon depicting a woman
introducing a man to a friend at a party. "Mary, I'd like you to meet Marty
Thorndecker," she began. "He's an economist, but he's really very nice."
Cartoons are data. That people find them amusing usually tells us something about
reality. Curious about what drove responses to the economist cartoon, I began asking
about the disappointed looks that appeared on people's faces when they first
discovered I was an economist. Invariably they mentioned unpleasant memories of an
introductory economics course. "There were all those incomprehensible graphs," was
a common refrain.
Needless to say, a course can be valuable even if unpleasant. Unfortunately, however,
most students seem to emerge from introductory economics courses without having
learned even the most important basic principles. According to one recent study, their
ability to answer simple economic questions several months after leaving the course is
not measurably different from that of people who never took a principles course.
What explains such abysmal performance? One problem is the encyclopedic range
typical of introductory courses. As the Nobel laureate George J. Stigler wrote more
than 40 years ago, "The brief exposure to each of a vast array of techniques and
problems leaves the student no basic economic logic with which to analyze the
economic questions he will face as a citizen."
Another problem is that the introductory course is increasingly tailored not for the
majority of students for whom it will be their only economics course, but for the
negligible fraction who will go on to become professional economists. Such courses
focus on the mathematical models that have become the cornerstone of modern
economic theory. These models prove daunting for many students and leave them
little time and energy to focus on how basic economic principles help explain
everyday behavior.
But there is an even more troubling explanation for students' failure to learn
fundamental economic concepts. It is that many of their professors may have only a
tenuous grasp of these concepts, since they, too, took encyclopedic introductory
courses, followed by advanced courses that were even more technical.
Consider, for example, the cost-benefit principle, which says that an action should be
taken only if its benefit is at least as great as its cost. Although this principle sounds
disarmingly simple, many people fail to apply it correctly because they do not
understand what constitutes a relevant cost. For instance, the true economic cost of
attending a concert - its "opportunity cost" - includes not just the explicit cost of the
ticket but also the implicit value of other opportunities that must be forgone to attend
the concert.
Virtually all economists consider opportunity cost a central concept. Yet a recent
study by Paul J. Ferraro and Laura O. Taylor of Georgia State University suggests
that most professional economists may not really understand it. At the 2005 annual
meetings of the American Economic Association, the researchers asked almost 200
professional economists to answer this question:
"You won a free ticket to see an Eric Clapton concert (which has no resale value).
Bob Dylan is performing on the same night and is your next-best alternative activity.
Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to
$50 to see Dylan. Assume there are no other costs of seeing either performer. Based
on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b)
$10, (c) $40, or (d) $50."
The opportunity cost of seeing Clapton is the total value of everything you must
sacrifice to attend his concert - namely, the value to you of attending the Dylan
concert. That value is $10 - the difference between the $50 that seeing his concert
would be worth to you and the $40 you would have to pay for a ticket. So the
unambiguously correct answer to the question is $10. Yet only 21.6 percent of the
professional economists surveyed chose that answer, a smaller percentage than if they
had chosen randomly.
Some economists who answered incorrectly complained that if people could apply the
cost-benefit principle, it did not really matter if they knew the precise definition of
opportunity cost. So the researchers asked another group of economists to answer an
alternative version of the question in which the last sentence was revised to read this
way: "What is the smallest amount that seeing Clapton would have to be worth to you
to make his concert the better choice?" Again, the correct answer is $10, and although
this time a larger percentage got it right, a solid majority still chose incorrectly.
When they posed their original question to a large group of college students, the
researchers found that exposure to introductory economics instruction was strikingly
counterproductive. Among those who had taken a course in economics, only 7.4
percent answered correctly, compared with 17.2 percent of those who had never taken
one.
Teaching students how to weigh costs and benefits intelligently should be one of the
most important goals of introductory economics courses. The opportunity cost of
trying to teach our students an encyclopedic list of technical topics, it seems, has been
failure to achieve that goal. As Mr. Ferraro and Ms. Taylor put it in the subtitle to
their paper, it is "a dismal performance from the dismal science."
Robert H. Frank has been teaching introductory economics at Cornell University
since 1972. He is the co-author, with Ben Bernanke, of "Principles of Micro
Economics."
Lost Opportunities
by Gary Foreman
Sometimes it's helpful to take a concept out of its original environment and see how it fits
someplace else. Today we're going to examine an economic theory and see how it might
apply to our personal lives.
The Economist website economist.com defines 'opportunity cost' as "The true cost of
something is what you give up to get it. This includes not only the money spent in buying
(or doing) the something, but also the economic benefits that you did without because
you bought (or did) that particular something and thus can no long buy (or do) something
else."
To put it simply, for everything you get, you give up something else. That's an important
concept. Let's consider an easy example. If you spend $15 on a pair of jeans, you do not
have that money available to buy a pizza. The "cost" of the jeans is not only $15. It is
also giving up a pizza.
Another way to look at opportunity cost is the amount of time we give up working to buy
a product. Suppose you make $12 per hour. Our tax rates are all different, but you can
pretty much expect to pay about 1/3 in Social Security and federal, state and local income
taxes. That leaves you with $8.
Let's further suppose that you go out to lunch with co-workers every day. And a typical
lunch costs you $6. Add a tip and sales tax and that lunch brings the total to $7.20. So
you give up 54 minutes of your life every day to work just to pay for lunch.
How about a different situation? Remember that an opportunity cost is what you give up
by making another choice. For instance, suppose that you choose to spend $100 on a
credit card knowing that you'll pay the minimum when the bill comes due. In effect,
you've given up about $140 in the future to make that purchase today. That's because
finance charges will be added to the cost of your purchase.
We face opportunity costs with our time, too. I can choose to spend an hour watching
TV. But that's an hour that I won't be talking to my wife, playing with the kids, doing
home projects or sleeping. Of course, watching TV might be the best use of that hour.
Still, it's a good idea to think about it before you spend the hour.
Sometimes the difference between choices is surprising. Suppose you spend $1 at break
time five days a week. No big deal. Right? But if you didn't spend that dollar every day
and put it in a bank at 3% interest, you'd have $3,000 in ten years. Or $7,100 in 20 years.
Or $20,000 in 40 years. So by choosing that $1 snack each day, you've given up a new
car when you retire. A good trade-off? Only you can decide.
There's also the possibility of trading money today for time tomorrow. For instance, you
could use the money from those work day snacks to allow you to retire 3 or 6 months
earlier than you would otherwise. Is it unusual to think of "banking" a few minutes each
day towards an early retirement? Perhaps, but it does give you a new perspective on
spending.
But, what about credit cards? Don't they make it possible to buy the things that we want?
Yes, you can use your plastic to do that.
But credit cards are deceptive. They lead you to believe that you can spend more than
you make. And, for a short time, that's probably true. But eventually you get to a situation
where you can only afford the minimum payment each month. Once there, you're back
where choosing to spend on one thing prevents you from buying something else. And,
you've also made the choice of paying interest to the credit card company on the monthly
balance instead of having that money for other uses.
So how can you use opportunity costs to help you live a happier life? By thinking of the
alternatives before you spend your time and money. Even though something looks good,
if you stop to compare, you might find something else that you'd prefer to spend your
time or money on.
Gary Foreman is a former financial planner and purchasing manager who currently edits
The Dollar Stretcher.com website and newsletters.
OPPORTUNITY COST
Should I go to work today? Should I go to college after high school? Should the
government spend money on a new weapon system? These are decisions that
are made everyday; however, what is the cost of our decisions? What is the cost
of going to work, or the decision not to go to work? What is the cost of college,
or not to go to college? Finally what is the cost of buying that weapon system, or
the cost of not buying that weapon? In economics it is called opportunity cost.
Opportunity cost is the cost we pay when we give up something to get
something else. There can be many alternatives that we give up to get
something else, but the opportunity cost of a decision is the most desirable
alternative we give up to get what we want.
Let’s look at our examples from above. If you have a job, what do you give up to
go to work? There are many possibilities. I could sleep in. If it is a nice day I
could take my dog to the park and play all day. Or, I could even spend the day
looking for a better job right? I give up all of these things if I choose to go to
work. What I get from working is a greater benefit than the cost of giving up
these things. But, opportunity cost is the most desirable thing given up not the
aggregate of the things we gave up.
Let’s look at the college example. We are all told to go to college so you can get
a good education and that will translate into a good job. How do we know that
college is such a good thing? How much college do we need? Let’s look at some
numbers from a 2002 study on education from the Institute of Government and
Public Affairs:
“There are distinct benefits of a college education. A study conducted in April of
2002, by the Institute of Government and Public Affairs for the Illinois Board of
Higher Education, showed the following benefits:
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Higher Earnings - Earning a bachelor’s degree provides the average
student with over $590,000 in future earnings. Similarly a professional
degree provides a present value to the student of almost $1.25 million in
future earnings.
Labor force participation rates and employment rates for people aged 25
and over increase with increased levels of education.
People with college experience contribute time and money to charitable
causes at a higher rate than those with less education.
Increased levels of education are associated with the increased likelihood
of voting or registering to vote.
In addition, college can provide many other benefits that are less tangible, and
will help your child become a better-rounded individual. Benefits include
increased self-awareness, the ability to think critically, and an opportunity to
meet many different people. Overall, the entire college experience will provide
your child with a lifetime of benefits”.
As we can see there are many benefits to a college education. So what are the
costs? There are monetary costs for sure. Also, we will spend four or more years
going to classes. We could be working and earning money instead of going to
college. Finally we will be giving up free time for study time that could be used to
do other things.
What about spending money on a missile defense system? In the fiscal year
2006 budget the taxpayers of Colorado will spend, as a fraction of overall federal
spending, $150.7 million for the ballistic missile defense system (Center on Arms
Control and Nuclear Proliferation). That same money could pay for 27,547 people
to get health care (Centers for Medicare and Medicaid Data Compendium) or,
37,384 scholarships for university students (National Center for Education
Statistics). These represent real choices that the government must make with
our Tax dollars. The opportunity costs in this case depend upon what you value
more military spending, health care, or college scholarships.
To get a graphical representation of how an economy makes decisions on what
to produce, or spend their money on, we will use a Production Possibilities
Curve.
Production Possibilities Curve shows the choices a country can make with
respect to its available resources.
Resources are Land, Labor, and Capital
Land- this refers to all natural resources used to produce goods and services.
This includes crops that are grown on a land, minerals that are mined from land
and rent that is paid to an owner of land for its use.
Goods and services are the things that we buy like mp3 players or hair cuts. A
good is a physical thing you can hold a service is some thing that gets used up
right after it is purchased.
Labor- this is the effort that an individual person puts into making a good or
service. This for this effort the person is paid a wage. Labor includes factory
workers, medical personal, and teachers. They all provide their labor for a wage.
Capital- this is anything that is used to produce other goods and services. If you
make cars you need machines to make the metal that is used in the cars. It is
also the truck that drives the cars to the dealer who sells them, and it is the
building that the cars are made in. All of these are the resource known as
capital.
If we look at a simple model of an economy for the country of Appleoplios it
shows that they can produce two goods apples and shoes, we can get a better
idea of what choices they have for production. When the resources of
Appleoplios are used to their full potential they can produce 100 million apples
(point A) a year or they can produce 4 million pairs of shoes (point B), but they
cannot produce all of both.
The line that connects points A and B is called a production possibilities frontier
(PPF). It represents all of the possible combinations of production possibilities
available to Appleoplios. If the economy decides that it needs apples and shoes
it can choose to produce at any point along the production possibilities curve. If
they choose to produce at point C they are making a combination of let’s say
shoes 3.5 million shoes and 50 million apples. With that in mind, what is the
opportunity cost of producing 3.5 million shoes? What did we give up to produce
the shoes? We gave up 50 million apples. Opportunity cost is always expressed
in terms of what we gave up in order to get something else. In this case we
gave up 50 million apples so we could move some resources in to the production
of shoes.
What about point D on the curve? At point D Appleoplios can produce 80 million
apples and 2 million shoes. What is the opportunity cost in terms of shoes?
How many shoes did they give up in order to make 80 million apples? They gave
up 2 million shoes. So using all the available resources the country of
Appleoplios has a variety of production choices. When the produce on the
production possibilities curve they are using all of their resources to there
maximum potential. This is their most efficient point.
What about some other possible points for consideration? Can they, for example
produce at point E? Yes they can. This is a point of under utilization of
resources. They are not operating at peak efficiency. Why would thy do this? If
Appleoplios wants to save some resource for future use then they would produce
at a point inside their PPF. Maybe they want to save water or another resource
to use at a later date.
What about point F? Can Appleoplios produce at point F? Not at this time.
They do not have enough resources to produce at this point. Would the country
like to produce at point F? Sure they would, but how do they do it? They need
to fine more resources or use technology to increase their production
possibilities. Like all economies they want to produce more then the year
before. They want to move their production possibilities curve out to point F and
further the next year.
This is a new PPF that is achieved with the introduction of new resources or a
new technology that can help the production process.
Opportunity cost
Opportunity cost is a term used in economics, to mean the cost of something in terms of opportunity
foregone. For example, if a city decides to build a hospital on some vacant land, the opportunity cost is the
other things that might have been done with that same land instead. In building the hospital, the city has
forgone the opportunity to build a sporting centre, or a car park, or sell the land off to reduce debt, and so
on.
The simplest way to estimate the opportunity cost of an economic decision is to consider the next best
alternative choice that could have been made, even though in reality most economic decisions involve
multiple alternatives. Note that opportunity cost is not the sum of the available alternatives, but rather any
particular one of them - the opportunity cost of the decision to build the hospital is the loss of the sporting
centre or the loss of the money to be made from selling the land, or the loss of any of the various other
possible uses, not all of these in aggregate.
It is often important to compare the opportunity costs associated with various courses of action. Different
opportunities may be difficult to compare along all the relevant dimensions. Economists typically use the
going market price of each alternative. This can lead to considerable difficulty in the case of alternatives that
do not have a market price. It is very difficult to agree on a way to place a dollar value on intangible assets.
(How does one calculate a dollar value for clean air, or seaside views, or pedestrian access to a shopping
centre, or untouched virgin forest?)
In consequence, intangibles tend to be ignored, and the powerful concept of opportunity cost, although
widely recognised as one of the very few profound "eternal truths of economics" (1
(http://www.ceda.com.au/Research/Bulletin/Governments%20and%20markets-Peter%20Drake.htm)), is
often stripped of meaning.
While opportunity costs are widely under-estimated, particularly by groups with a particular political or
financial gain in mind, the opposite tactic is employed too. Here, the proponent of a particular point of view
exaggerates an opportunity cost as a political tactic. A good example is the computer software industry,
which regularly calculates the "opportunity cost" of software piracy by assuming that, if piracy did not exist,
every individual with an illegal copy of any particular program would have chosen to pay the full retail price
to buy the legitimate packaged version instead - thus neatly ignoring another of the eternal truths of
economics, that marginal demand always falls as prices rise.
Nevertheless, although it is hard to account for, opportunity cost is very real. Because opportunity costs are
so hard to calculate, they represent the hidden cost[?] of an economic decision. Frederic Bastiat suggested
that ignoring hidden costs can make certain decisions appear to have no cost at all. He described this as the
broken window fallacy.
Since the work of the Austrian economist Friedrich von Wieser opportunity cost has been seen as the
foundation of marginal theory of value.