Sunday, October 9, 2011

Some thoughts about opportunity cost...

The concept of the opportunity cost of an action being used to determine economic behavior was well explained in the two written articles, and clarified in the pod cast. The applications that were provided for examples demonstrated how the theory opportunity costs applies to current situation. However, the last section of “Getting the Most out of Life: Opportunity Costs” by Russell Roberts, self-sufficiency vs. relying on others, made me wonder how the ability to determine an opportunity cost has adjusted to the technological advancements and globalization that have taken place thus far, and how it will continue to adapt to changes in the future. Roberts asserts that, “Ultimately, anything close to genuine self-sufficiency is the road to poverty.” As society becomes more dependent on a local, national, and global level, the ability to understand and calculate opportunity costs is increasingly tied to the capacity to act in a way that will maximize utility.

Two of the four prominent economists mentioned in regard to their economic theory in the beginning of the essay, Adam Smith and Alfred Marshall, both made their contributions before many of the significant advancements in communication, transportation, production, and social justice that we enjoy today were either developed or widely recognized. Several notable effects of the progression in these areas have been: an increase in the availability and variety of goods and services, shifts in religious and political institutions, globalization, and an increase in the accessibility of information and education. Although the other two economists who were noted, Friedrich Hayek and Milton Friedman, were able to witness many of these changes, their last scholarly economic contributions were published in 1988 and 1982, respectively. I am not questioning the validity of these men or their theories, I am merely suggesting that their perception on determining the opportunity cost of an action might not give adequate consideration to additional factors that have been created by our constantly evolving global environment.

This caused me to consider several question. How have opportunity costs been affected by the technological and cultural changes that have transpired over the last century? Or on the other hand, how are changes in our ability to predict opportunity costs affecting individual and collective values and resource allocation? Do individuals faced with making decisions, both personal and corporate, have access to enough information about their options to make the choice that will maximize their utility?

The dilemma of inadequate information is also presented in the Roberts’ article in the section “the return on your investments”. The example given about a given mutual return investor only having a 12% return, which was 3% less than the average return, demonstrates the difficulty of making decisions that will maximize utility because there is insufficient information about all of the available options. As number of options for investment is positively correlated with the amount of goods and services being developed, it is increasingly difficult to have sufficient information about each option to determine the opportunity cost before making an investment. However, lack of information, even though technology has made it more accessible, is at fault for more than just the undesirable opportunity cost in regard to mutual funds that is given as an example in Robert’s article.

Charles Wheelan explores the problem of imperfect information and how it contributes to economic issues, as well as social issues, in his book, Naked Economics.

What we don’t know can hurt us. Economists study how we acquire information, what we do with it, and how we make decisions when all we get to see is a book’s cover. Indeed, the Swedish Academy of Sciences recognized this point in 2001 by awarding the Nobel Prize in Economics to George Akerlof, Michael Spence, and Joseph Stiglitz for their seminal work on economics and information. Their work explores the problems that arise when rational people are forced to make decisions based on incomplete information, or when one party to a transaction knows more than another. Their insights are relevant to some of our most pressing social issues, from genetic screening to discrimination in the workplace. (82)

Wheelan concludes his discussion on the topic by stating:

In the world of Econ 101, all parties have ‘perfect information.’ The graphs are neat and tidy; consumers and producers know everything they could possibly want to know. The world outside of Econ 101 is more interesting, albeit messier. A state patrolman who has pulled over a 1990 Grand Am with a broken taillight on a deserted stretch of Florida highway does not have perfect information. Nor does a young family looking for a safe and dependable nanny or an insurance company seeking to protect itself from the extraordinary cost of HIV/AIDS. Information matters. Economists study what we do with it, and, sometimes more important, what we do without it. (96-97)

A person’s ability to determine opportunity costs certainly has an impact on the course of action that they will pursue. Even though understanding opportunity costs is increasingly more important as society becomes more dependent, the developments that have contributed to many recent social and economic advancements have also made it more difficult to accurately predict the opportunity cost of an action. Fortunately, we have economists like Akerlof, Spence, and Stiglitz who have concentrated their research to better understand the impact that information, or lack thereof, can have on an individual’s ability to make decisions that will maximize their utility.


Wheelan, Charles. Naked Economics. New York: W.W. Norton & Company, 2002. 82-97. Print.


  1. Awesome post. Bonus points for questioning.

  2. This was so good I want to delete my post and hide under a rock.

  3. This is also an interesting post. First, allow me to answer to the first point about technology and globalization and the effects on opportunity costs. Adam Smith used to say that the division of labor (and also of knowledge) is limited by the size of the market. Globalization is nothing more than the expression of the expansion of the market or more exactly of markets. As barriers to trade have been lowered, more countries have embraced the market economy and trade, and therefore we have observed an increase in specialization resulting from the increasing of markets. Now you have markets in dog walkers, wedding planners, shoppers, etc. because of that increase of specialization where people will specialize in occupations where they have a low opportunity cost. As a result of that specialization, productivity has increased, economies of scale have emerged and therefore costs of production have decreased significantly. Innovation and technologies are largely the results of the division of labor and knowledge. So if one has to look at the effects of that increased division of labor & knowledge and globalization has done to opportunity costs of not buying goods and services from people who have a lower opportunity costs than you in producing those goods & services and doing things yourself, the only conclusion we can derive is that this opportunity cost has increased. For you to be able to produce that iPhone as opposed to China, you will have to sacrifice a significant amount of time that you could be dedicated to do something else for which your talents are more suited.

    With regard to Wheelan's Naked Economics references to the work of Akerlof, Stliglitz, and Spence. The thing that Wheelan doesn't address is that true there are asymmetric information everywhere but it's also true that people are aware of those and that's why markets have developed mechanisms to mitigate those problems. You might be less informed than the seller of the used car about the true quality of the car but that's why markets have developed such things as certification, used car warranties, CarFax, Consumer Reports, Consumer Ratings. If you go to EBay or any online seller of used products (I often buy used rare used books and often they come from foreign countries). I know that I am less informed about the condition of the book than the seller, I know that the seller might take my money and never send me the book but I do have a mechanism to minimize those risks, previous buyers' ratings and comments on their experience using that seller. If anything new technologies, the net, etc. have allowed to reduce these asymmetric information problems.
    Akerlof was the first to really articulate the problem with asymmetric information but he clearly stated that there were market institutions to alleviate these problems and so did Kenneth Arrow when he talked about moral hazard which is another information problem.

    As a side note Wheelan belongs to that groups of economists that when market fails, the only solution is government and tends to ignore that sometimes the government solution to the problems make often those problems worse than the problem itself. Wheelan largely falls into what we call the Nirvana Fallacy, the idea that if the real world doesn't meet the perfect competitive world with perfect information, government must intervene.

    if you allow me, here's a great quote by Ronald Coase: "Until we realize that we are choosing between social arrangements, which are all more or less failures, we are not likely to make much headway"

  4. Well for some reason my post didn't go through so I have to rewrite it but it will be shorter.
    Let me first address the question about globalization and technology. If anything globalization means that we have increased our interdependence, which results from the increased division of labor and knowledge. Because of that increased division of knowledge, productivity has increased, we have witnessed economies of scale resulting from that increased productivity, which has led to lower costs of production because goods and services are not supplied by individuals or firms in regions or countries where they have a comparative advantage (meaning a lower opportunity cost than us) in producing these goods and services. So if anything the effects of that increased division of labor and knowledge and resulting interdependence that we call globalization has increased the opportunity costs for us to do those things ourselves. What it takes a worker from China to assemble an Iphone it would take us much more time to do and as a result with that time spent assembling that iPhone we would be foregoing the opportunity to develop new drugs, innovate, new technologies, etc. To do things we have a greater comparative advantage. Similarly we could imagine that would apply to us making our own shirts, shoes, pants, hats, etc.

    My second point is related to the question about asymmetric information. In my original post, I pointed that Wheelan ignores points made by Akerlof that there are market institutions/mechanisms that have emerged to mitigate those problems. When you go online buy a used book (like I sometimes do and sometimes I buy those books in foreign countries because of my research), I am aware that the reseller of the book might not tell me the truth about the book condition or might not even shipped the book to me even though I paid for it. Being aware of this, I go read previous customers ratings and reviews. Similarly, you have mechanisms such as warranties, certifications, consumer's reports, Underwritten labs that are private market base mechanisms that have emerged to help us minimize these information problems. Kenneth Arrow who's really the first to formalize these issues mention in the postscript of his paper on Healthcare where he discussed these asymmetric information problems is clear on this there are market institutions that have emerged to minimize the problems.

    Coase had a great quote, which is: "Until we realize that we are choosing between social arrangements, which are all more or less failures, we are not likely to make much headway"

    His argument is that while the perfectly competitive model is useful as an imaginary construction to analyze what's happening when things are not perfect, to understand market failures, it's a very poor tool to be used for normative purposes and develop policies.

    I would invite you to read this article by Gary Becker in the WSJ that he wrote last month.

  5. If you enjoy economic thinking perhaps you might be interested in addressing this opportunity costs challenge.