Opportunity cost and the real world

Is real-world decision making influenced by opportunity costs? Consider your own decision to attend college. Your opportunity cost of going to college is the value of the next best alternative, which could be measured as the salary you would earn if you had chosen to go directly into full-time work instead. Every year you stay in college, you give up what you could have earned by working that year. Typically, students incur opportunity costs of $80,000 or more in forgone income during their stay in college.

But what if the opportunity cost of attending college changes? How will it affect your decision? Suppose, for example, that you received a job offer today for $250,000 per year as an athlete or an entertainer, but the job would require so much travel that school would be impossible. Would this change in the opportunity cost of going to college affect your choice as to whether to continue in school? It likely would. Going to college would mean you would have to say goodbye to the huge salary you’ve been offered. You can clearly tell from this example that the monetary cost of college (tuition, books, and so forth) isn’t the only factor influencing your decision. Your opportunity cost plays a part, too.

Even when their parents pay all the monetary expenses of their college education, some students are surprised to learn that they are actually incurring more of the total cost of going to college than their parents. For example, the average monetary cost (tuition, room and board, books, and so forth) for a student attending college is about $10,000 per year (S40,OOO over four years). Even if the student’s next best alternative were working at a job that paid only $15,000 per year, over four years, that would amount to $60,000 in forgone earnings, So, the total cost of the student’s education would be $100,000 ($40,000 in monetary costs paid by the parents and $60,000 in opportunity costs incurred by the student).

Now consider another decision made by college students-whether to attend a particular class meeting. The monetary cost of attending class (bus fare, parking, gasoline costs, and so on) remains fairly constant from day to day. Why then do students choose to attend class on some days and not on others? Even though the monetary cost of attending class is fairly constant, a student’s opportunity cost can change dramatically from day to day.

Some days the next best alternative to attending class may be sleeping in or watching TV. Other days, the opportunity cost may be substantially larger, perhaps the value of attending a big football game, getting an early start on spring break, or having additional study time for a crucial exam in another class. As options like these increase the cost of attending class, more students will decide not to attend.

Failure to consider opportunity cost often leads to unwise decision making. Suppose that your community builds a beautiful new civic center. The mayor, speaking at the dedication ceremony, tells the world that the center will improve the quality of life in your community. People who understand the concept of opportunity cost may question this view. If the center had not been built, the resources might have funded construction of a new hospital, improvements to the educational system, or housing for low-income families. Will the civic center contribute more to the well-being of the people in your community than these other facilities? If so, it was a wise investment. If not, your community will be worse off than it would have been if decision makers had chosen a higher valued project.

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Opportunity cost

An unpleasant fact of economics is that the choice to do one thing is, at the same time, a choice not to do something else. Your choice to spend time reading this blog is a choice not to spend the time playing video games, listening to a math lecture, or going to a party. These things must be given up because you decided to read this lob instead. As we indicated in earlier posts, the highest valued alternative sacrificed in order to choose an option is called the opportunity cost of that choice. In economics when we refer to the “cost” of an action, we are referring to its opportunity cost.
Opportunity costs are subjective because they depend upon how the decision maker values his or her options. They are also based on the expectations of the decision maker- what he or she expects the value of the forgone alternatives will be. Because of this, opportunity cost can never be directly measured by someone other than the decision maker. Only the person choosing can know the value of what is given up. This makes it difficult for someone other than the decision maker-including experts and elected officials-to make choices on that person’s behalf. Moreover, not only do people differ in the trade-offs they prefer to make, but their preferences also change with time and circumstances. Thus, the decision maker is the only person who can properly evaluate the options and decide which is the best, given his or her preferences and current circumstances.
Monetary costs can be measured objectively in terms of dollars and cents (or yen, lira, and so forth). They also represent an opportunity cost. If you spend $20 on a new CD, you must now forgo the other items you could have purchased with the $20-a new shirt, for example. However, it is important to recognize that monetary costs do not represent the total opportunity cost of an option. The total cost of attending a football game, for example, is the highest valued opportunity lost as a result of both the time you spend at the game and the amount of money you pay for your ticket. In cases like the purchase of a CD, where there is minimal outlay of time, effort, and other resources to make the purchase, the monetary cost will approximate the total cost. Contrast this with a decision to sit on your sofa and listen to your new CD, which involves little or no monetary cost, but has a clear opportunity cost of your time. In this second case, the monetary cost is a poor measure of the total cost.

Employer-guaranteed sale

As an additional incentive for a proposed transfer or relocation, some companies and employers may guarantee the sale of the employee’s current home. Often, the employer will simply guarantee to purchase the property, and resell it later.
If an employer has guaranteed to purchase the applicant’s current residence as part of a transfer or relocation, the existing mortgage loan on that residence is not treated as long-term liability. The applicant can obtain a new mortgage loan without having to bother with the sale of his or her current home.
As usual, however, there are always conditions:
1. The employer’s responsibility to purchase the property is clearly defined and documented.
2. The borrower’s financial responsibility for the property is clearly short-term.
3. It is readily apparent that the employer has the financial capacity to honor the guarantee.