What is Opportunity Cost?

Economic decision-making requires comparing costs and benefits. Unlike the explicit costs an accountant would record in a balance sheet, opportunity costs are implicit. There’s no line on an accountant’s balance sheet for these costs but they are equally important in making the right economic choice.

Economists define opportunity cost as the foregone value of the next best alternative. Essentially, an opportunity cost is whatever you give up to do something else. If you give up your secure job making $50,000 to start your own business, your opportunity cost is $50,000, because you could be earning that much working your old job. If your new business brings you less than $50,000 then your economic profit is negative. This is true even if your business makes a $30,000 accounting profit. You made $30,000, but you would be better off at your old job making $50,000. However, if you make more than $50,000 at your new job, your economic profit is positive, and you made the right decision!

One example of the idea of opportunity cost is that running a coffee shop earning $30,000 a year might be economically profitable for someone with an opportunity cost lower than $30,000, but won’t be economically profitable for someone whose opportunity cost is higher than $30,000, whether that’s an accountant or an NBA player. Both individuals have a higher opportunity cost of running a coffee shop. That is, people are willing to pay them significantly more to provide a different good or service, whether that’s doing their taxes or shooting 3-pointers.

In fact, this concept of opportunity cost has been formulated into an economic law known as the Law of Comparative Advantage. This law states that the total output of a group of individuals will be greatest when the output of each good is produced by the person (or group of people) with the lowest opportunity cost for that good. That is to say, you don’t have to be the absolute best at something to be the person (or group of people) who should make a particular good or service. And, even if you can make everything better than someone else, you still can benefit from trading with them if you have different opportunity costs. What things you should produce with your time depends on your relative ability to produce those things.

Let’s look at a simple example first. Suppose that two travelers, Jane and Tommy, are stranded on a deserted island. Jane, working alone all day, can either catch four fish or collect 10 coconuts in one day. If she spends half her time on each activity, at the end of the day she will have two fish and five coconuts. Tommy, working alone all day, can either catch 10 fish or collect 10 coconuts. If he splits his time evenly, at the end of the day he will have five fish and five coconuts. Together, they will have seven fish and 10 coconuts. BUT, if they work together, they will both benefit. Tommy can catch 10 fish, and Jane can collect 10 coconuts. Consider what happens if Jane trades five coconuts for four fish. Jane gets four fish and five coconuts, more food than if she worked by herself to get two fish and five coconuts. Tommy also benefits. He now gets six fish (instead of five) and five coconuts. How is this possible? It comes down to opportunity cost. Tommy’s cost of collecting one coconut is one fish. That’s his opportunity cost. In the time it takes him to collect one coconut, he could have been doing something else—namely, fishing. The same is true for Jane. She has to stop fishing to go collect coconuts. In her case though, she gives up four-tenths of a fish to go collect one coconut. Her Opportunity cost is lower. If she agrees to trade with Tommy and specializes in collecting coconuts, she frees Tommy up to do the thing he is comparatively better at.

One surprising extension of the idea of opportunity costs is that if Tommy gets even better at fishing, this will benefit Jane too! Why? Getting better at fishing makes Tommy a comparatively more expensive coconut-gatherer. He now has to give up more fish every time he wants to drink coconut water. And because his opportunity cost increases, he’s willing to trade more fish for a coconut with Jane!

Imagine that after spending a week learning the area and making some better fishing tools at night, Tommy can now gather 20 fish in a day instead of 10. His opportunity cost of collecting coconuts has increased from giving up one fish to collect one coconut to giving up two fish for just one coconut. He’s now willing to trade up to two fish for one coconut! So he would be willing to trade 10 fish for five coconuts. Now Jane can have 10 fish and five coconuts, and Tommy can have 10 fish and five coconuts! Both Jane and Tommy are made better off by Tommy increasing his fishing skills!

This concept of comparative advantage doesn’t just apply to individuals stranded on a desert island collecting fish and coconuts. It applies to any situation where individuals, or groups of individuals, have different opportunity costs. This means that you might hire an assistant to book travel and schedule meetings for you, even if you can do those things pretty quickly, because that frees up your time to do something more valuable. It also means you’re never likely to see movie stars, NBA players, or the president mowing their own lawn. Their opportunity cost of time is too high. Think of all the things they could do with the extra time.

Not only does comparative advantage explain why you should trade with your neighbor, it explains much of international trade. In fact, David Ricardo, the English economist credited with first articulating the idea of comparative advantage, used the idea to explain why England and Portugal should trade. In Ricardo’s example, Portugal was able to use fewer labor hours to produce both wine and cloth. Why would they bother to trade with England? Well, since England was (and still is) poorly suited to producing wine, England’s opportunity cost of producing cloth was much lower than Portugal’s. Portugal’s opportunity cost of producing cloth was higher, since workers who weren’t producing cloth could be working to produce wine. If England and Portugal agreed to trade, both countries would be better off. England could acquire wine more cheaply by trading cloth than growing grapes in greenhouses. And Portugal could acquire cloth more cheaply by specializing in wine and trading with England.

Comparative advantage is a revolutionary idea. It says that just by changing who produces which goods, everyone can be made better off. When combined with Adam Smith’s idea of the division of labor, that is that workers can get more productive by specializing in one task, we can better understand the explosion of prosperity since the Industrial Revolution.

Questions

Let’s go over a few questions now.

1. The law of comparative advantage says that total productivity is highest when:

1. Individuals who are the best in their fields produce those goods
2. Individuals with the highest opportunity cost produce goods and services.
3. Individuals produce goods for which they are the lowest opportunity cost producers.
4. Everyone is randomly assigned a specialization and will improve rapidly over time with practice.

2. Dave wants to renovate his apartment. He is trying to decide whether he should install new bathroom tile himself or hire someone to do it for him. Dave estimates that it will take him 10 hours to install the tile. He has found a contractor who is willing to install the tile for $100/hr, and who estimates the work would take him six hours. If Dave’s alternative to installing the tile is to work 10 hours of overtime, at what rate would he need to get paid to make it worth hiring the contractor?

1. $10/hr
2. $20/hr
3. $47/hr
4. $61/hr
5. Dave should just install the tile himself.

3. James decided to leave his accounting job at a large firm earning $80,000 and start his own office. He rented an office for $30,000 and hired a part time assistant for an additional $30,000. In the first year, his office brought in $120,000 in revenue. What was his economic profit?

1. -$20,000
2. $10,000
3. $60,000
4. $120,000
5. None of the above

That’s all for now, thanks for watching and happy studying!