Download Opportunity Cost Working Definition: Opportunity cost of a

Opportunity Cost
Working Definition:
Opportunity cost of a production or consumption choice = The value of the next best option
e.g. (Chapter 1, Problem 2) The opportunity of going to school is the value of the forgone option
to work (i.e. the salary associated with that job). As such, assuming that the average salary that
one would expect is increasing as the level of education increases, the opportunity cost of going
to school increases with more education. Note that opportunity cost is only what you’re giving
up by not doing your next best choice, and doesn’t include anything you have to pay given the
choice you made. In this case, tuition paid for one more year of schooling isn’t an opportunity
cost, but a direct cost - more on this later.
e.g. (Chapter 1, Problem 3) The most preferred option is working at a consulting firm since the
options are listed in ranked order of preference. The opportunity cost of working at a consulting
firm is the value of the next best alternative, which for Allison is attending community college
for two years.
This example gets a little confusing. How can an opportunity cost be negative? After all, by not
going to community college for 2 years, isn’t Allison saving money? That’s true, but since
Allison has ranked community college as her second choice, it must give some utility to her,
despite the tuition she would have to pay. Her utility may be decreased because she has to pay
for it, but it still has to be high enough that she prefers community college to, say, tutoring a rock
star’s child.
That doesn’t mean we totally ignore tuition in this case, it just factors into the utility she gets
from community college. The opportunity cost of being a consultant for two years is the value
associated with the education at a community college minus the cost of the tuition at community
college of $10,000 over two years. In this case, the tuition of the next best option is factored into
the opportunity cost of being a consultant since it diminishes from the value of the next best
option, which is by definition what opportunity cost measures. The value of the next option (i.e.
working as a tutor) is not included in the opportunity cost of being a consultant since it is not the
next most preferred option.
Say Allison couldn’t get that consulting job she wanted, so her first choice isn’t even an option
anymore. Then she would be down to picking between community college and being a tutor. In
that case, the opportunity cost of doing option 2 (going to community college) would be the
foregone utility from the next best available option - being a rock star tutor. Remember, if she
has chosen to go to school for another year, now we don’t call the tuition she’s paying
“opportunity cost”, but “direct cost”, just like in the problem discussed above.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005
Another concept: Total cost of a consumption or production choice
Total cost of a consumption choice = opportunity cost of the next best option + direct cost
of the chosen option
e.g. Going to the movies: If one is trying to decide whether to go to the movies (a two hour
excursion, with a ticket cost of $8), what is the total cost of doing so? First there’s the $8 ticket,
which is the direct cost, the cost one pays to do the chosen option. Say the next best alternative to
going to the movie is to work for $10 an hour. Then the opportunity cost of going to the movies
is the wages forgone from working (i.e. $20). The total cost of going to the movies is the
opportunity cost of $20 plus the direct cost of going to the movies of $8, for a total of $28.
If I was trying to decide if I should go to the movie or not, I’ll want to compare the benefits and
costs of doing so. If I could measure the benefit I get by going to the movies in dollars at $25,
the relevant calculation would be to weigh the total benefit of going to the movies ($25) versus
the total cost of going to the movies ($8 + 2 x $10 = $28). Bottom line, someone who has taken
Econ 1A would tell you that it is not worthwhile to go to the movies in this situation since the
total cost (which by definition includes the opportunity cost) outweighs the total benefits.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005