Opportunity Cost Working Definition: Opportunity cost of a production or consumption choice = The value of the next best option e.g. (Chapter 1, Problem 2) The opportunity of going to school is the value of the forgone option to work (i.e. the salary associated with that job). As such, assuming that the average salary that one would expect is increasing as the level of education increases, the opportunity cost of going to school increases with more education. Note that opportunity cost is only what you’re giving up by not doing your next best choice, and doesn’t include anything you have to pay given the choice you made. In this case, tuition paid for one more year of schooling isn’t an opportunity cost, but a direct cost - more on this later. e.g. (Chapter 1, Problem 3) The most preferred option is working at a consulting firm since the options are listed in ranked order of preference. The opportunity cost of working at a consulting firm is the value of the next best alternative, which for Allison is attending community college for two years. This example gets a little confusing. How can an opportunity cost be negative? After all, by not going to community college for 2 years, isn’t Allison saving money? That’s true, but since Allison has ranked community college as her second choice, it must give some utility to her, despite the tuition she would have to pay. Her utility may be decreased because she has to pay for it, but it still has to be high enough that she prefers community college to, say, tutoring a rock star’s child. That doesn’t mean we totally ignore tuition in this case, it just factors into the utility she gets from community college. The opportunity cost of being a consultant for two years is the value associated with the education at a community college minus the cost of the tuition at community college of $10,000 over two years. In this case, the tuition of the next best option is factored into the opportunity cost of being a consultant since it diminishes from the value of the next best option, which is by definition what opportunity cost measures. The value of the next option (i.e. working as a tutor) is not included in the opportunity cost of being a consultant since it is not the next most preferred option. Say Allison couldn’t get that consulting job she wanted, so her first choice isn’t even an option anymore. Then she would be down to picking between community college and being a tutor. In that case, the opportunity cost of doing option 2 (going to community college) would be the foregone utility from the next best available option - being a rock star tutor. Remember, if she has chosen to go to school for another year, now we don’t call the tuition she’s paying “opportunity cost”, but “direct cost”, just like in the problem discussed above. Another concept: Total cost of a consumption or production choice Total cost of a consumption choice = opportunity cost of the next best option + direct cost of the chosen option e.g. Going to the movies: If one is trying to decide whether to go to the movies (a two hour excursion, with a ticket cost of $8), what is the total cost of doing so? First there’s the $8 ticket, which is the direct cost, the cost one pays to do the chosen option. Say the next best alternative to going to the movie is to work for $10 an hour. Then the opportunity cost of going to the movies is the wages forgone from working (i.e. $20). The total cost of going to the movies is the opportunity cost of $20 plus the direct cost of going to the movies of $8, for a total of $28. If I was trying to decide if I should go to the movie or not, I’ll want to compare the benefits and costs of doing so. If I could measure the benefit I get by going to the movies in dollars at $25, the relevant calculation would be to weigh the total benefit of going to the movies ($25) versus the total cost of going to the movies ($8 + 2 x $10 = $28). Bottom line, someone who has taken Econ 1A would tell you that it is not worthwhile to go to the movies in this situation since the total cost (which by definition includes the opportunity cost) outweighs the total benefits.
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