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Marshall and Shackle on opportunity cost
I have long viewed opportunity cost as a gross concept, not in net terms or as another phrase for consumer surplus. So I said "$50" in response to Alex's Clapton/Dylan question. Here is my recent email to Alex, edited for clarity...
...or forget all the fancy talk of "opportunity cost." Let's say you ask, "how much does that apple cost"?
The correct answer is $1.00, the price (gross).
The correct answer is not "the consumer surplus on what the dollar could buy elsewhere" (a net concept).
You can still figure in information about price to get both consumer surpluses and the correct decision.
"*Opportunity* cost" is a means of saying that we don't just stop at the money ($1.00), but rather we think in terms of a foregone good or service (perhaps a pear, etc.).
But just as "cost" was a gross term, so does "opportunity cost" stay a gross term, it does not become a net one. Only the word "opportunity" has been added to "cost," so why leap from gross to net thinking?
Buchanan and others blur all this when they start talking about the value dimension of opportunity cost. On one hand this is properly subjectivist. But it also encourages people to move to the "net" dimension, and notions of consumer surplus, rather than focusing on the *opportunity*.
G.L.S. Shackle wrote about a "skein of imagined alternatives." This captures the "gross" idea properly, and remains subjectivist, but it doesn't encourage the leap into the mix of net thinking and consumer surplus, which remains a separate concept.
I don't have any quarrel with Alex's economics; as far as I can see this point is semantic. (I'll also admit that my gross perspective on opportunity cost is somewhat anachronistic; it is one reason why mainstream economists work directly with consumer surplus.) What disturbs me is how few economists gave $50 or $40 as the right answer; the actual answers were close to randomly distributed. Most Web-based sources appear confused on the net vs. gross issue, but at least they hover across the $40 and $50 options.
Posted by Tyler Cowen on September 5, 2005 at 06:13 AM in Economics | Permalink
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Comments
My intro econ textbook (of which I am rather fond) states explicitly that "all costs are opportunity costs". What's your opinion of that statement?
It seems reasonable to me that the cost of anything is measured by the value, not the price, of the foregone option. The price is set by the market, and may have little relationship to the subjective value I assign.
Costs, it seems, are also subjective. When I am thirsty, the opportunity cost for forgoing a glass of water is different than when I have had plenty to drink. The opportunty costs for a gallon of gas depend entirely on how bad I need a gallon of gas now, not the price.
Posted by: Mike at Sep 5, 2005 10:44:10 AM
I too answered $50 for this question, but now I am confused. You say that opportunity cost should be measured in terms of gross value, instead of the net value-cost. I suppose the problem here is a conflict between using opportunity cost to show that there are implicit costs in decisions and using it to actually make decisions.
Consider this addition to the problem: You value the Eric Clapton concert at $30.
Now pretend to be making the decision which concert to see. If you use the gross definition of opportunity cost you can say "If you forgo Bob Dylan, it will cost you $50." So it seems like the real cost of going to Eric Clapton is $50. On the other side, if you go to Bob Dylan, it will cost you $30. So you would choose Dylan when comparing these costs. But this leaves you with less consumer surplus.
I believe opportunity cost must be used to make decision like this, because how else can imaginary firms work the possible cost of renting or selling their land into their cost functions? Defined as a gross value, opportunity cost seems useless.
If I have made any ghastly mistakes, please, correct me.
Posted by: Matt at Sep 5, 2005 11:16:43 AM
Sorry - the first sentence of that last paragraph makes no sense. I should have deleted it.
Posted by: Mike at Sep 5, 2005 11:18:41 AM
I think the difference between the Clapton/Dylan example and the apple example is that with the Clapton/Dylan question, *time* is the scarce resource: you can only go to one of the concerts, and before getting your Clapton ticket, Dylan was the best use of your evening. In such a case it makes sense to compare the alternatives in terms of which would give higher consumer surplus, and so if you would have been willing to spend more than $10 to see Clapton that's what you do, and if you had only been willing to spend some amount less than $10 to see Clapton you go to Dylan - $10 is the opportunity cost.
Posted by: Michael at Sep 5, 2005 11:37:20 AM
Time doesn't make a difference. You are choosing between one thing and another, that's all. In both the concert & the fruit examples, you get to pick one good or the other. The fact that the good's consumption is spread out over time doesn't make a difference. Consider, it might take you 5 hours to eat an apple....
If you wanted to work time into the example, you would have to compare the opportunity costs associated with forgone time. In the example, these are assumed to be equal, i.e., both concerts are expected to last the exact same amount of time. If one concert lasted only half as long as the other, then you would have to consider that the shorter concert allows you the musical enjoyment and extra time.
This is the only way time would ever come into the question, and it doesn't illuminate the issue of how to quantify opportunity cost at all.
Posted by: Matt at Sep 5, 2005 12:08:30 PM
I wasn't very clear, so I'll try again. It wasn't so much the foregone value of hours of time that I meant, but rather that the person must choose a way to spend this single evening, and cannot do both. We already know that before the Clapton ticket came available, the Dylan concert was the best way to spend the evening, and it promised $10 in net benefit. Spending the evening at Clapton implies foregoing the $10 net benefit of Dylan. I can't see how one could derive a value different from $10 for opportunity cost of attending Clapton.
Posted by: Michael at Sep 5, 2005 1:39:01 PM
Hmmm, I don't understand what definition of consumer surplus is being used here. The standard one is 'area between the demand function and a price'. I don't see a demand function here. I guess you could go with 'the difference between willingness to pay and a price', but then, uh, the answer is still 10$ (the 'consumer surplus' you give up by seeing Clapton).
Either I'm really missing something, or they teach some crazy economics somewhere out there.
And bringing Buchanan, Weiser and subjective vs. objective considerations is really overthinking what is obviously meant to be a simple question.
Posted by: radek at Sep 5, 2005 3:09:20 PM
The whole mess about the term, "opportunity cost" is just that, the term itself. Two words that pull our thinking in opposite directions are joined together and confuse the heck out of us. "Opportunity" attracts us, but "cost" repels us.
After wrestling with this confusion for some time, I decided to think of it in this way: think of everything that's out there for you to buy as an "opportunity space." So all the stuff, the things you may purchase, constitute this "opportunity space" each with a price tag attached to it. This price tag to me is a "sacrifice tag". At the instance I am making the choice to buy one thing, in my mind I am taking into account not just the price of this thing, but the price tags of all the other things in this opportunity space. It's like walking into a toy store (or an electronics store:-))
So we have three opportunities here in this opportunity space. Free Eric Clapton concert opportunity doesn't cost me anything, so I don't have to sacrifice anything, BUT, if I make this choice and go to Eric Clapton concert, I will lose the benefit of $10 that the Dylan opportunity today gives me. I think the opportunity cost lurks somewhere between that "BUT", the moment of hesitation, and the "IF" that leap forward into the decision.
All the same, the term "opportunity cost" is confusing as hell if we have to make so many leaps to get it only to hit our heads thinking how simple that is. When a normal person asks about "how much does it cost me?" she is already only thinking about the "it" and simply wants to know if the cost is affordable in her mind. She may think about what *else* she could do with these $s instead of buying that "it" but this deliberate weighing of options doesn't happen all that much in normal people. She just wants to get the transaction done, and is too busy bargaining the heck out of the guy who's selling that "it."
So, my point is, don't assign confusing names to easy notions and blame people if they don't get it. If I keep insisting on referring Alex as Tyler pretty soon all three of us are in a fist fight, and it doesn't matter that you are economists:-)
Talkativeman (Raj)
Posted by: RK at Sep 5, 2005 7:23:22 PM
The area between the demand curve and brice is aggregate consumer surplus. An individual's consumer surplus is indeed the difference between his reservation price (max he's willing to pay) and the price he actually pays.
Posted by: Matt at Sep 5, 2005 7:25:54 PM
'Time doesn't make a difference.'
In the example given it makes all the difference. Because the ticket is free to Clapton you still have the $40 you otherwise would have paid to attend Dylan.
The only resource you are EXPENDING is your time. Since both performances are at the same TIME you can't be at both. That's what makes the foregone opportunity of Dylan the opportunity cost of going to see Clapton.
We're arguing about the dollar value of it. And, none of the answers given from which to choose are very compelling.
Posted by: Patrick R. Sullivan at Sep 5, 2005 8:51:39 PM
I think Tyler has this one wrong (a rare event). The opportunity cost of the apple is the $1.00 plus the forgone consumer surplus on the alternative use of the dollar if there is any. (Normally, though, there would be no consumer surplus from a marginal unit of expenditure.) We don't net off the $1 cost of the alternative as that cost has to be incurred to buy the apple. In making the decision on whether to buy the apple we compare the total value of the apple to the opportunity cost. If it is worth more than $1 we buy it; if not, we don't. In the Clapton/Dylan case, we have to net out the $40 cost and use only the consumer surplus of the Dylan concert as that cost of $40 would not be incurred at the Clapton concert. We then compare the value of the Clapton concert to the true opportunity cost ($10). If the value is more than $10 we go; if not, we don't--exactly the same as with the apple.
Posted by: Seamus Hogan at Sep 5, 2005 10:07:12 PM
Matt, if we gonna go splitting hairs, then the term 'consumer surplus' in the way that Marshall used it applies to the area below the MARKET demand curve and a given price. Aggregate consumer surplus would be something like adding up all the consumer surpluses (surplusi?) across all goods and markets. I stress 'market' because it just shows how far removed is the concept of cs from that of opportunity cost. I see no market here. No demand functions either. Which is why it's no excuse to say that you got the question wrong because you confused the two (or blame it on the question for the same reason.) The idea of consumer surplus hardly applies to an individual then, though, like it's been said, the difference between WTP and a price is somewhat analogous. But not really. Even then, 'individual consumer surplus' would be something like - if I purchase x amount of good y then my ics is the sum (the area!) of all the net benefit I get from all the x units I've bought. I get a certain amount of benefit (- price) from the first unit, a certain lesser (if I've got diminishing marginal utility) amount from the second unit bought (- price) etc. up until the very last unit (- price). So again, it'd be the sum of the benefits I get from all my x units (- price times number of units). Now it could be that you only have positive utility from the first unit and none after that. In that case the 'individual consumer surplus' and 'willingness to pay minus price' would conicide. But really, the difference between the two concepts is pretty fundemental.
"If you forgo Bob Dylan, it will cost you $50." No, it will cost you 10$ because you'd have to shell out 40$ for it.
Here's a perhaps easier version of the same problem:
Your roomate Joe says he'll give you some money for free. The only stipulation is that you don't take any money from your friend John, your second best option. John has told you that he'll give you 50$ for free. Trouble is, to pick up John's money you gotta take a bus to his apartment, which costs 40$. What is the opportunity cost of taking Joe's money?
(you have all the freakin time in the world so the time it takes to take the bus is freakin costless! In fact if some cost or anything else isn't explicitly mentioned then don't go thinking it's there. Don't novelize the question. This isn't English Lit).
Posted by: radek at Sep 6, 2005 1:57:03 AM
I see opportunity cost as the forgone benefit of the next best alternative. Which is $10 for the oportunity to go to the Dylan concert. The opportunity cost has to be the net number or otherwise it won't be of any use in your decision making. If you value the clapton concert at $9, you go see dylan. If you value the clapton concert at $11, you go see clapton.
Posted by: Joe O at Sep 6, 2005 2:38:52 AM
I still think that the correct answer is $10. The buyer will be willing to go to the Clapton concert as long as his valuation for the concert is greater than its opportunity cost, $10. Tyler's argument hinges on the implicit assumption that the buyer pays the same price, $40, for both tickets. Given this, it makes sense to use the gross valuation, $50, as the value of the foregone alternative. However, in this particular question the price of the Clapton ticket is zero, and this requires a net instead of a gross interpretation. Now imagine a third alternative. The price of the Clapton ticket is $30 whereas the Dylan ticket still costs $40 and is valued at $50. In this example, the opportunity cost of the Clapton concert will be $40.
Posted by: Anil at Sep 6, 2005 3:37:31 AM
Patrick: You’re totally missing what I was saying. Every decision we make involves time, and for some reason everyone seems caught up in believing that concerts are something special. When deciding to eat lunch, you typically get to choose just one restaurant, if you go to Taco Bell you can’t go to Burger King. Both services are being provided at the same time, and you can only have one. What I am saying is that both require the same amount of time investment from you, thus the time element cancels out when doing the cost-benefit analysis. Decisions don’t need some sort of time element to contain opportunity costs.
Like I said before, if you wanted to introduce time as an important factor, then the amount of time it takes to consume each concert must differ, then a time cost would be introduced. So say Clapton is 4 hours, Dylan is 3 hours and your time is worth $30/hour. So going to Clapton costs (4*30)+10 dollars and going to Dylan costs (3*30)+0 dollars.
radek: Yes you’re right, consumer surplus is usually confined to discussions of social welfare, so let me rephrase. The “true” opportunity cost arises when individuals make their utility maximizing decisions, comparing the costs and benefits of different expenditures. The net benefit is to the individual what consumer surplus is to society. Thus when looking at an individual choosing between one net benefit and another, the definition of opportunity cost appears: The (next best) net benefit of the good s/he forgoes.
(and BTW, for your problem, there’s always the bus ride back. haha)
Posted by: Matt at Sep 6, 2005 8:58:40 AM
Here's another way to look at the $10 opportunity cost.
If you'd already bought the $40 Dylan ticket, the opportunity cost of exercising your free option to see Clapton would indeed be $50 (which is the nominal value attached to the pure unadulterated pleasure you'd get from consuming the services of the Dylan concert.) But you haven't sunk the $40 yet, and you have full flexibility of whether to do so or not, independent of whether you decide to see Clapton. You can see Clapton and still buy $40 worth of goods & services with your un-sunk $40, which means that the $40 is not opportunity cost.
I wonder whether opportunity cost should always be measured (and stated) vis-a-vis a well-defined alternative, as in "The opportunity cost of going to Clapton, instead of buying a ticket to Dylan for $40, is $10." Since opportunity cost is defined as being related to the next-best alternative, and the problem contains enough information to calculate this next-best alternative, the explicit definition of the OC is not really necessary for the problem to be well-defined. Explicitly pointing out what that alternative is, however, would certainly help principles-of-econ students get the answer right. I'm guessing it would, as well, help the poor professors who got befuddled with the question as posed.
Posted by: DC at Sep 6, 2005 12:18:08 PM
It's obviously a round trip bus ticket, what else?
Posted by: radek at Sep 7, 2005 1:28:02 AM
If you assume that I put a value on the Dylan concert of $50, and I gave that concert up to go see Clapton, then you can assume I value the Clapton concert at above $50.
I would have paid a bit more to see Clapton, but I didn't have to, and I didn't have to put a number on Clapton, I just knew, for me, it had more "value" (units of joy, lets say), that I felt was greater than the $50 value for Dylan. But if I had to put a number on Clapton, let's just say I valued it at $1 more. I would have paid $51 to see Clapton. I just got lucky and didn't have to, but $50 is still the cost of foregone opportunities, isn't it? The net, $1 is NOT the opportunity cost.
So given all that, what is the cost of foregone opportunity? I still argue that it's $50. I gave up a Dylan concert that was worth $50.00 of value to go see Clapton. The net of what I actually paid or would have paid is the answer to a different question, isn't it?
Posted by: Jay roach at May 13, 2006 9:36:49 AM
First off opportunity cost, is just another name for economic cost. You may regard it as only in gross terms but this is is no way true for economic costs, which does have a more rigorous definition.
What we're are actually comparing is the value of a Clapton concert versus the value of the chance to exchange $40 for something you value you at $50. The latter is $10.
Maybe this will awaken memories of Econ 100: The explicit or accounting cost of going to the Clapton concert is nil. The economic cost of going to the concert is the explicit costs plus the implicit cost of $10 (the value of the foregone alternative). If you value the concert greater than $10, you go to the concert. The ECONOMIC benefit is greater than the ECONOMIC cost.
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