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Opportunity Cost

Prof. Mario Villarreal-Diaz explains the scarcity inherent in the world, and how this necessarily implies a world of tradeoffs.  In such a world, the pursuit of a choice requires forgoing all other potential choices.  Opportunity cost is simply what is given up when a choice is pursued.  This is an important concept, as it provides guidance as to where scarce resources will be more productive.

  • Opportunity Cost [Article]: David R. Henderson covers the basics of opportunity cost and its connection to everyday action.

  • A Fable of the OC [Article]: Michael Munger demonstrates the principle of opportunity cost through a story about purchasing expensive concert tickets.

  • Opportunity Cost and Hidden Inventions [Article]: Dwight R. Lee, through a series of examples, shows that opportunity costs play a large role in decision making.

  • Free Lunch Myth (Video): Milton Friedman demonstrates that all types of government spending carry a cost.

  • Why Soaking the Rich Won't Work (Video): Milton Friedman explains how excessive taxation on the rich destroys wealth by reducing the amount of investment in the economy.

Opportunity Cost

We have limited resources, and we have scarce resources, and we have all sorts of wants. So what we economists try to understand is how people make those tradeoffs when facing different choices and committing themselves to a given course of action.

The value of what you have to give up in order to pursue a choice is what we call the opportunity cost. A classic example is the opportunity cost of attending school and paying tuition. You’re using your time and talent to go and acquire more education. But you could be using that time and talent to work. In the context of choice, what you really want to know is should I go to college or not? And in that, you take into account several things, like I want to be better educated because in the future that will pay me more. And then, so you say, well, right now it makes sense for me even though I could work and make this much money, because if I invest in my human capital and I acquire more skills and talent, I will be in a better position to make more money in the future. So right now it makes sense. The opportunity cost is a powerful tool because it allows us to understand the tradeoffs that are involved with making choices.

Let’s say that you’re a lawyer and you are a great typist and you have to type a whole bunch of things. You can hire someone. And then the decision of hiring someone versus doing it yourself involves a tradeoff, because you can use your time typing, or you could use your time attending a very important case. So what you really need to compare is, what is the opportunity cost of me typing, of the time I use? Let’s say that you can make $100 per hour and you only pay someone for typing $20 per hour. So it would make sense for you to allocate your time and skills in the $100 activity, namely attending the big case, instead of typing because your opportunity cost of typing is way too high. What is your opportunity cost of typing? A hundred dollars. That’s what you would have to give up in order to commit yourself to the choice of typing your own documents.

Public officials have a responsibility to allocate public funds. And when they do that they face different options, like should I build a school? Should I build a road or a hospital? Or maybe should I not spend this money at all and give it back to the taxpayers? Those different options have different opportunity costs, and in assessing those tradeoffs, it’s important to have in mind alternative value of those resources or talents or skills.

When you’re taxing or you’re collecting taxes, what you’re doing is taking money out of taxpayers to allocate it on your own terms or in your own decision-making process. But that money could be used by those taxpayers in their own endeavors or in their own decisions. And the question is, who has better information in allocating those resources? Now that’s not to say that it’s not valuable to build public schools or to build roads. What it’s to say is that information regarding the best alternative use of those resources tends to be better at the individual level.

It is important to be aware of the concept of opportunity cost, because it facilitates the process of deciding where scarce resources can be more productive in the short and the medium and the long run. And if we are aware of where those resources can be more valuable—and opportunity cost enables us to do that or facilitates that process—then we will make better decisions.

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