The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Opportunity Cost

  • James M. Buchanan
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_1433

Abstract

The concept of opportunity cost (or alternative cost) expresses the basic relationship between scarcity and choice. If no object or activity that is valued by anyone is scarce, all demands for all persons and in all periods can be satisfied. There is no need to choose among separately valued options; there is no need for social coordination processes that will effectively determine which demands have priority. In this fantasized setting without scarcity, there are no opportunities or alternatives that are missed, forgone, or sacrificed.

Keywords

Choice Opportunity cost Scarcity 

JEL Classifications

D0 

The concept of opportunity cost (or alternative cost) expresses the basic relationship between scarcity and choice. If no object or activity that is valued by anyone is scarce, all demands for all persons and in all periods can be satisfied. There is no need to choose among separately valued options; there is no need for social coordination processes that will effectively determine which demands have priority. In this fantasized setting without scarcity, there are no opportunities or alternatives that are missed, forgone, or sacrificed.

Once scarcity is introduced, all demands cannot be met. Unless there are ‘natural’ constraints that predetermine the allocation of end-objects possessing value (for example, sunshine in Scotland in February), scarcity introduces the necessity of choice, either directly among alternative end-objects or indirectly among institutions or procedural arrangements for social interaction that will, in turn, generate a selection of ultimate end-objects.

Choice implies rejected as well as selected alternatives. Opportunity cost is the evaluation placed on the most highly valued of the rejected alternatives or opportunities. It is that value that is given up or sacrificed in order to secure the higher value that selection of the chosen object embodies.

Opportunity Cost and Choice

Opportunity cost is the anticipated value of ‘that which might be’ if choice were made differently. Note that it is not the value of ‘that which might have been’ without the qualifying reference to choice. In the absence of choice, it may be sometimes meaningful to discuss values of events that might have occurred but did not. It is not meaningful to define these values as opportunity costs, since the alternative scenario does not represent a lost or sacrificed opportunity. Once this basic relationship between choice and opportunity cost is acknowledged, several implications follow.

First, if choice is made among separately valued options, someone must do the choosing. That is to say, a chooser is required, a person who decides. From this the second implication emerges. The value placed on the option that is not chosen, the opportunity cost, must be that value that exists in the mind of the individual who chooses. It can find no other location. Hence, cost must be borne exclusively by the chooser; it can be shifted to no one else. A third necessary consequence is that opportunity cost must be subjective. It is within the mind of the chooser, and it cannot be objectified or measured by anyone external to the chooser. It cannot be readily translated into a resource, commodity, or money dimension. Fourth, opportunity cost exists only at the moment of decision when choice is made. It vanishes immediately thereafter. From this it follows that cost can never be realized; that which is rejected can never be enjoyed.

The most important consequence of the relationship between choice and opportunity cost is the ex ante or forward-looking property that cost must carry in this setting. Opportunity cost, the value placed on the rejected option by the chooser, is the obstacle to choice; it is that which must be considered, evaluated, and ultimately rejected before the preferred option is chosen. Opportunity cost in any particular choice is, of course, influenced by prior choices that have been made, but, with respect to this choice itself, opportunity cost is choice-influencing rather than choice-influenced.

Other Notions of Cost

The distinction between opportunity cost and other conceptions or notions of cost is best explained in this choice-influencing and choice-influenced classification. Once a choice is made, consequences follow, and these consequences may, indeed, involve utility losses, either to the person who has made initial choice or to others. In a certain sense it may seem useful to refer to these losses, whether anticipated or realized, as costs, but it must be recognized that these choice-determined costs, as such, cannot, by definition, influence choice itself.

A single example may clarify this point. A person chooses to purchase an automobile through an instalment loan payment plan, extending over a three-year period. The opportunity cost that informs and influences the choice is the value that the purchaser places on the rejected alternative, in that case the anticipated value of the objects which might be purchased with the payments required under the loan. Having considered the potential value of this alternative, and chosen to proceed with the purchase, the consequences of meeting the loan schedule follow. Monthly payments must be made, and it is common language usage to refer to these payments as ‘costs’ of the automobile. The individual will clearly suffer a sense of utility loss as the payments come due and must be paid. As choice-influencing elements, however, these ‘costs’ are irrelevant. The fact that, in a utility dimension, post-choice consequences can never be capitalized is a source of major confusion.

Economists recognize the distinction being made here in one sense. With the familiar statement that ‘sunk costs are irrelevant’, economists acknowledge that the consequences of choices cannot influence choice itself. On the other hand, by their formalized constructions of cost schedules and cost functions, which necessarily imply measurability and objectifiability of costs, economists divorce cost from the choice process.

Essentially the same results hold for accountants, who normally measure estimated costs strictly in the ex post or choice-influenced sense. Those ‘costs’ estimated by accountants can never accurately reflect the value of lost or sacrificed opportunities. Numerical estimates could be introduced in working plans for alternative courses of action prior to decision, but such estimates of opportunity costs would be the accountant’s measure of the values for projects not undertaken rather than the value of commitments made under the project chosen.

As suggested, choice-influencing opportunity costs exist only for the person who makes choice. By definition, opportunity costs cannot ‘spill over’ to others. There may, of course, be consequences of a person’s choice that impose utility losses on other persons, and it is sometime useful to refer to these losses as ‘external costs’. The point to be emphasized is that these external costs are obstacles to choice, and hence a measure of forgone opportunities, only if the individual who chooses takes them into account and places his own anticipated utility evaluation on them.

Opportunity Cost and Welfare Norms

The source of greatest confusion in the analysis and application of opportunity cost theory lies in the attempted extension of the results of idealized market interaction processes to the definition of rules or norms for decision makers in non-market settings. In full market equilibrium, the separate choices made by many buyers and sellers generate results that may be formally described in terms of relationships between prices and costs. Under certain specified conditions, prices are brought into equality with marginal costs through the working of the competitive process. Further, the general equilibrium states described by these equalities are shown to meet certain efficiency norms.

Prices may be observed; they are objectively measurable. A condition for market equilibrium is equalization of prices over all relevant exchanges for all units of a commodity of service. From this equalization it may seem to follow that marginal costs, which must be brought into equality with price as a condition for the equilibrium of each trader, are also objectively measurable. From this the inference is drawn that, if marginal costs are then measured, ‘efficiency’ in resource use can be established independently of the competitive process itself through the device of forcing decision makers to bring prices into equality with marginal costs.

The whole logic is a tissue of confusion based on a misunderstanding of opportunity cost. The equalization of marginal opportunity cost with price for each trader is brought about by the adjustments made by each trader along the relevant quantity dimension. The fact that the marginal opportunity costs for all traders are all brought into equalization with the relevant uniform price implies only that traders retain the ability to adjust quantities of goods until this condition is met. There is no implication to the effect that marginal opportunity costs are equalized in some objectively meaningful sense independently of the quantity adjustment to price.

Consider an idealized market for a good that is observed to be trading at a uniform price of $1 per unit. The numeraire value of the anticipated lost opportunity is $1 for each trader. But it is only as quantity is adjusted that the trader can bring the numeraire value of his subjectively experienced and anticipated utility sacrifice into equality with the objectively set price that he confronts. The anticipated value of that which is given up in taking a course of action is no more objectifiable and measurable than the anticipated value of the course of action itself. The two sides of choice are equivalent in all respects.

Independently of market choice, there is no means through which marginal opportunity costs can be brought into equality with prices. Hence, any ‘rule’ that directs ‘managers’ in non-market settings to use cost as the basis for setting price is and must remain without content. There is, however, a second equally important criticism of the welfare rule that opportunity cost reasoning identifies, quite apart from the measurability question. Even if the first criticism is ignored, and it is assumed that marginal opportunity cost can, in some fashion, be measured, instructions to ‘managers’ to use cost to set price must rely on ‘managers’ to behave, personally, as robots rather than rational utility-maximizing individuals. Why should a ‘manager’ be expected to follow the rule? Would he not be expected to behave so that marginal cost, that which he faces personally, be brought into equality with the anticipated value of the benefit side of choice? The fact that the ‘manager’ remains in a non-market setting insures that he cannot be the responsible bearer of the utility gains and losses that his choices generate. His own, privately sensed, gains and losses, evaluated either prior to or after choice, must be categorically different from those anticipated for principals before choice and enjoyed and/or suffered by principals after choice.

Opportunity Cost and the Choice Among Institutions

As noted earlier, in the absence of ‘natural’ constraints that predetermine allocation, the introduction of scarcity introduces the necessity of choice, either directly among ultimate ‘goods’ or indirectly among rules, institutions, and procedures that will operate so as to make final allocative determinations. Opportunity cost in the second of these choice-settings remains to be examined. In a sense, the use of institutionalized procedures to generate allocations of scarce resources may eliminate ‘choice’ in the familiar meaning used above and is akin in this respect to the ‘natural’ constraints noted. Results may emerge from the operation of some institutional process without any person or group of persons ‘choosing’ among endstate alternatives, and, hence, without any subjectively-experienced opportunity cost. Despite the absence of this important bridge between cost and choice in the ordinary sense, however, values may be placed on the ‘might have beens’ that would have emerged under differing allocations. The patterns of these estimated value losses, over a sequence of institution-determined allocations, may enter, importantly, in a rational choice calculus involving the higher-level choice among alternative institutional procedures for allocation. In this higher-level choice, opportunity cost again appears as the negative side of choice even if ‘choice’ in the standard usage of the term is not involved in the making of allocations, taken singly.

Consider the following extreme example. There are two mutually exclusive thermostat settings for a building, High and Low. An institution is in being that uses an unbiased coin to ‘choose’ between these two settings each day. It is meaningful for an individual to discuss the potential value to be anticipated if the setting is High rather than Low, even if the individual does not make the selection, individually or as a member of a collective. The setting that is ‘chosen’ by the coin flip has consequences for individual utility and these consequences may be anticipated in advance of the actual ‘choice’. So long as the institutional procedure remains in effect, however, with respect to a single day’s selection, the anticipated value lost by one setting of the thermostat rather than the other cannot represent opportunity cost.

Suppose, now, that instead of the unbiased and equally weighted device, the institution in being is one that allows all persons in the building to vote, each morning, on the thermostat setting with the majority option ‘chosen’ for the day. Assume, further, that the group of voters is large, so that the influence of a single person on the expected majoritarian outcome is quite small. It is important to emphasize that, in this procedure, as with the coin toss, no person really ‘chooses’ among the alternative end-states. Each voter confronts the quite different, intrainstitutional choice between ‘voting for High’ and ‘voting for Low’, with the knowledge that any individual has relatively little influence on the outcome. In the choice that he confronts, the voter cannot rationally take into account the anticipated losses from the ultimate alternatives, either for himself or for others, in any full-value sense of the term. The loss anticipated from, say, a Low thermostat setting may be estimated to be valued at $1,000 for the individual. Yet if he considers himself to have an influence on the outcome of the voting choice only in one case out of a thousand, the expected utility value of the anticipated loss will be only $1 in terms of the numeraire. This $1 will then represent the numeraire value of the opportunity cost involved in voting for High.

Since these same results hold, with possibly differing values, for all voters, no one ‘chooses’ in accordance with fully evaluated gains and losses. ‘Choices’ emerge from the institutional procedure without full benefit – cost considerations being made by anyone, taken singly or in aggregation. In the relevant opportunity-cost sense, effective choice is shifted to that among alternative institutions. The results of the ‘choices’ made within an institution over a whole sequence of periods (over many days in our thermostat example) may, of course, become data for the choice comparison among institutions themselves. And, to the extent that the individual, when confronted with a choice among institutions, knows that he is individually responsible for the selection, the whole opportunity cost logic then becomes relevant at the level of institutional or constitutional choice. This result is accomplished, however, only if each person in the relevant community does, in fact, become the chooser among institutional rules. Only if, at some ultimate level of institutional-constitutional choice the Wicksellian unanimity rule becomes operative, hence giving any person potential choice authority, can the opportunity cost of alternatives for choice be expected to enter and to inform individual decisions.

Summary

Opportunity cost is a basic concept in economic theory. In its rudimentary definition as the value of opportunities forgone as a result of choice in the presence of scarcity, the concept is simple, straightforward, and widely understood. In the analysis of choices made by buyers and sellers in the marketplace, the complexities that emerge only in rigorous definition of the concept remain relatively unimportant. But when attempts are made to extend opportunity cost logic to non-market settings, either in the derivation of norms to guide decisions or in application to choice within and among institutions, the observed ambiguity and confusion suggest that even so basic a concept requires analytical clarification.

Bibliography

  1. Alchian, A. 1968. Cost. In Encyclopedia of the social sciences, vol. 3. New York: Macmillan.Google Scholar
  2. Buchanan, J.M. 1969. Cost and choice. Chicago: Markham, Republished as Midway Reprint, Chicago: University of Chicago Press, 1977.Google Scholar
  3. Buchanan, J.M., and G.F. Thirlby (eds.). 1973. LSE essays on cost. London: Weidenfeld and Nicholson. Reissued by New York University Press, 1981.Google Scholar
  4. Coase, R.H. 1960. The problem of social cost. Journal of Law and Economics 3: 1–44.CrossRefGoogle Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • James M. Buchanan
    • 1
  1. 1.