Opportunity Cost

In making decisions, an agent (such as a person, organization, or firm) chooses actions from a set of competing alternatives. By choosing any particular action, an agent must forgo others. For example, spending an evening dining precludes one from simultaneously attending a movie. The value of such forgone alternatives is a decision's “opportunity cost.” Continuing the present example, dining's opportunity cost is the utility (or value) one would have received from attending a movie.

Opportunity cost is, perhaps, economics' most fundamental notion. To see this, recognize that if resources are scarce (which they almost certainly are), then acting in a manner that “does no harm” is logically impossible. Any action causes resources to be employed in one way but not another. Consequently, even actions that produce tremendous benefits must simultaneously do so at some cost.

In using the term “opportunity cost,” people frequently refer only to relatively obscure costs (such as the value of lost time). Strictly speaking, however, all economic costs are opportunity costs. Some are simply more obvious than others. For example, if one pays $1000 for medical supplies, then that $1000 can no longer be allocated to other uses (such as meeting payroll). Such obvious costs are sometimes called “explicit” opportunity costs. These costs usually involve a market transaction with an explicit dollar payment. In contrast, “implicit” opportunity costs emerge from lost opportunities but do not necessitate a corresponding market transaction or payment. Often a single decision and consequent action create both explicit and implicit opportunity costs. Extending the present example, the value of time spent checking and stocking medical supplies adds an implicit opportunity cost to the $1000 explicit opportunity cost.

Identifying a prospective action's full opportunity cost (both explicit and implicit) is essential for making sound decisions. Consider how physicians allocate time. Time spent with a particular patient necessarily precludes that time from being allocated to an alternative endeavor. The opportunity cost of spending time with a patient is thus the value of, say, treating a different patient, contributing to a community outreach event, or even enjoying the company of family members. Even the best decision must produce an associated cost (lost opportunity) in this sense. Despite this necessity, however, a decision may still be “optimal” if the consequent action's opportunity cost is less than the ensuing benefit.

Identifying full opportunity costs is also essential for promulgating sound policy. Advocates sometimes extol a proposed policy's virtues by, in effect, arguing that the policy will be worthwhile if it “saves only one person.” Although the magnitude of the policy's benefits may be difficult to measure, the advocate understands that even a poorly designed policy is likely to produce benefits for at least one person. By this standard, almost any policy's appearance can be made attractive.

What our hypothetical advocate ignores, however, is that allocating resources to his or her cause necessarily precludes those same resources from producing alternative benefits. If these forgone benefits (the policy's opportunity cost) exceed those produced by the policy, then the policy will reduce welfare. Notice that this net reduction occurs even if the policy truly saves at least one person! In this light, activities such as “fund raising” might be more accurately characterized as “fund transferring.”

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