Sunday, September 20, 2009

The Value of Foregone Opportunities

This week we'll be thinking about a simple, but powerful concept: Opportunity costs. The opportunity cost of any decision - the true cost - is the value of the next best alternative forgone in order to pursue that decision.

In a world of scarcity our decisions are often constrained by choices between two or more mutually exclusive opportunities. We face scarcity in our budgets: Given a limited income I might be faced with a choice between purchasing a candy bar or a soda. The opportunity cost of the Snickers I buy is the Coke I don't, or vice versa. We face scarcity in time: The time I take to write blog posts is time I don't get to sleep, work on other projects, or goof off. The opportunity cost of this post is the other paper I'm not writing instead.

We all face scarcity. Limited budgets, limited time, limited resources...

The opportunity cost of keeping your savings under your mattress is the interest you could've earned had you invested it. The opportunity cost of a college education might be the income going unearned due to your delayed entry into the job market. In the Ricardian trade models Robin I are JUST SOOOO FOND OF STUDYING IN ECON 463 the opportunity cost of producing more of good X would be the units of good Y that aren't made instead.

Often these trade-offs seem simple, but for such a seemingly simple concept, opportunity costs can also be notoriously difficult to work with.

One problem lies in how exactly we're supposed to quantify and measure opportunity costs. This problem is embodied in the distinction between 'economic costs' and 'accounting costs'. Since an opportunity cost might not involve any explicit monetary terms or a measurable price index that can be incorporated into a financial statement accountants ignore opportunity costs. If only economists had that luxury. Remember that a firm might be operating at a profit according to their balance sheets but operating at an 'economic' loss when opportunity costs are taken into account.

Opportunity costs are sometimes referred to as 'hidden costs' because of the difficulty involved in considering the forgone utility that might've been generated by an option that was never pursued.

For example say the local government is thinking about different uses for a currently empty plot of land. There's a lot they can do with that land. They could use it to build a new sports stadium, or a school, or a parking lot; but they can't do that all, there's a limited amount of land available. Whatever they end up deciding to build the cost wont just be represented by the final price tag. We also have to consider the opportunity costs associated with the forgone value of all the things that weren't built on that land.

Say the government decides to use the land to build a stadium only to find that their local team sucks and no one will pay to watch them play in their new multi-million dollar building. The townspeople realize the land would've been put to much better use had they built something else. Besides a painful lesson in sunk costs they also learn that there's a great deal of speculation and guesswork involved in comparing different opportunity costs.

Hindsight is usually 20/20 and sometimes we find that what we thought was the best available opportunity really wasn't, thus 'hidden costs'.

2 comments:

  1. Richard,

    Opportunity costs scare the bejeezus out of me, for precisely the reasons you mentioned. How do we account for them? They are as you said, "the value of the next best alternative forgone in order to pursue that decision."

    I imagine a recursive downward spiral of coke fueled, late night accounting. I often think about how I would have used the new concepts I'm learning in my previous endeavors. I started and ran a small independent music store, "The Anderson Music Exchange", in Anderson, Indiana. I used the typical small business accounting tools. I had a ledger that recorded all the money that came in and went of the store. I also had a computerized inventory system that would update on a sale by sale, purchase by purchase basis. I'd supplement the daily changing inventory with quarterly inventory audits so I could keep up with shoplifters. (Seriously, what kind of self-respecting criminal would steal used CD of Blondie's greatest hits?) I only did the basic income minus costs equals profit type of analysis on my store. Some years, I operated my store at a profit according to my balance sheets, and other years I didn't.

    In your blog post you wrote: "Remember that a firm might be operating at a profit according to their balance sheets but operating at an 'economic' loss when opportunity costs are taken into account." Well, crap! Maybe I was operating at an economic loss the entire time? How would I know?

    I'd need an inventory/balance book with three columns. Column one would list the item and the quantity. Column two would list the cost paid for the item, or the amount it sold for. The third column would have the opportunity cost of the item. An example might be: Item - Alvarez Acoustic Guitar Qty: 1. Purchased for $150 from wholesaler. Opportunity cost: Two $75 Copley Acoustic Guitar Starter Kits.

    This is where the recursive, late night, coke fueled accounting comes in. Every opportunity cost represents a decision tree, a fork in the road. I'd have to keep a ledger with my imaginary inventory. Later in the week someone would come in to buy a Copley Acoustic Guitar Starter Kit, and I wouldn't have one, because I used the money to buy the Alvarez instead! So, I'd open up my imaginary, opportunity cost, inventory, and mark down that I made an imaginary sale for an imaginary profit of $75. (The margins were higher on the cheap gear; I'd have only made $40 bucks selling the Alvarez.) I'd take the imaginary opportunity cost profit I just made on the imaginary sale of the next best alternative forgone, and enter that into a third ledger which accounts for where I spend my imaginary profits.

    At the end of the year I take the 48 or so sets of books I have to keep to account for all my opportunity cost, fractally distilated, alternate reality, post hoc ergo somnium propter hoc transactions. You know what I think I would find if I practiced this holistic economic accounting?

    Some years I'd be operating at an "economic" profit, and other years I'd be operating at an "economic" loss.

    ARRRRRRRGGGGGHHHHHHH! I love economics. All the fun of a hangover without the cost of the booze.

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  2. The future GMU PHD student has spoken

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