- Scarcity
- Money problems — shopping and budgeting · coming soon
- Factors of production
- The production possibility frontier
- Comparative advantage · coming soon
What did that choice really cost?
The last lecture ended with a question. Scarcity forces every person to choose. So when you choose one thing, what exactly do you give up?
Start with something ordinary. A friend gives you a free ticket to a concert on Saturday evening. The ticket cost you nothing. So what did the concert cost you?
Most people answer "nothing". That answer is wrong, and this lecture shows why. On Saturday evening you could have done something else: worked a paid shift, revised for a test, or spent time with your family. By going to the concert, you gave one of those up. That is a real cost, even though no money left your pocket.
Economists have a name for this cost. Once you can see it, you will notice it in every decision you make, from lunch at school to a country's budget.
The next best thing you give up
Go back to the canteen from the last lecture. You have $2 and you are hungry. You could buy rice with curry, noodle soup, a puff and a fruit cup, or a mango drink. Each of these uses up most or all of your $2, so you can have only one of them.
Suppose you rank them. Rice with curry is your favourite. Noodle soup is second. The puff and fruit cup is third, and the mango drink is last. You buy the rice.
What did you give up? It is tempting to say "the other three". But think again. If the rice had been sold out, you would not have bought all three of the others. You would have bought the noodle soup. So the noodle soup is the thing the rice really cost you.
The opportunity cost of a choice is the next best alternative that you give up when you make it.
It is one alternative, the second-best, not all of them added together.
Two parts of this definition need care.
The first is "next best". You only ever give up one alternative, because you could only ever have had one. In the canteen, you could have had the soup or the puff and fruit cup or the drink. You could never have had all three with $2. So adding them up would count things you could never have had.
The second is "alternative". An opportunity cost is a thing you give up, not an amount of money you pay. Sometimes it can be measured in money, as when the thing you give up is a wage. Often it cannot. Your evening, a meal with your family or an hour of sleep can all be opportunity costs.
That is it. That is the whole idea. Every choice has a cost, and the cost is the best thing you did not choose.
On the day you buy the rice, the canteen runs out of noodle soup before you reach the counter. Does the opportunity cost of your rice change?
Show the answer
Yes. The soup is no longer an alternative, because you could not have had it. Your next best alternative is now the puff and fruit cup, so that is the opportunity cost. Opportunity cost depends on what is actually possible at the moment you choose. It is not a fixed label on the rice.
Time has an opportunity cost too
Money is only one resource. The last lecture showed that time is another, and time is the one everybody has the same amount of: 24 hours a day.
Every hour you spend on one thing is an hour you cannot spend on anything else. An hour of revision costs an hour of something: football, a game, sleep, or paid work. An hour of football costs an hour of revision, if revision was your next best use of that hour.
When the next best use of your time is paid work, the opportunity cost of your time can be measured in money. It is the pay you give up. This is why economists often say that "time is money". The phrase is older than economics. Benjamin Franklin used it in 1748, in a short piece of advice to a young tradesman.
Now look again at the free concert ticket. The ticket cost you no money. But the evening did cost you something.
Leila is given a free ticket to a concert on Saturday evening. She cannot sell it. If she does not go, her next best choice is to work a Saturday evening shift at her uncle's shop, which pays $30. Her third choice is to stay at home and rest. What is the opportunity cost of going to the concert? Choose an answer before you read on. (This example is invented.)
Leila is given a free ticket to a concert on Saturday evening, and she cannot sell it. Her next best choice is a shift at her uncle's shop paying $30, and her third choice is to rest at home. The opportunity cost of going to the concert is the $30 of pay she gives up. It is not $0, because the free ticket did not make her evening free. It is not the price printed on the ticket, because she never had that money. It is not the $30 plus an evening at home, because she could only have done one of those things.
If you chose $0, you are in good company. In 2005, researchers Paul Ferraro and Laura Taylor asked 199 economists and economics students a similar question about a free concert ticket. Only 21.6% chose the answer the researchers counted as correct. That is fewer than you would expect if everyone had guessed at random. Other economists later argued that the question itself was unclear, but the lesson stands. "Free" is one of the most misleading words in everyday life.
This also fits with the last lecture. A free good is one that nobody has to give anything up for. Leila's ticket was free to her, but her evening was not free. Going to the concert has an opportunity cost, so it is not a free good.
Money cost and opportunity cost together
Many choices have both kinds of cost. You pay some money, and you also give up some time. To compare two choices fairly, you must count both.
Here is an everyday case. To reach a city centre, you can take a bus or a taxi. The bus is cheap but slow. The taxi is quick but expensive. Which is "cheaper" depends on what your time is worth to you, and that depends on what else you could do with it. Try it below.
The bus costs $2 and takes 60 minutes. The taxi costs $15 and takes 20 minutes. Set how much an hour of your time is worth: the value of the best other thing you could do with it, such as paid work. The bars show the full cost of each choice: money plus time.
Value of an hour:
This table shows the full cost of each choice for different values of an hour. Full cost = fare + value of an hour × hours used. The bus takes 1 hour and the taxi takes one-third of an hour.
| Value of an hour | Bus ($2, 60 min) | Taxi ($15, 20 min) | Lower full cost |
|---|---|---|---|
| $0 | $2.00 | $15.00 | Bus |
| $10 | $12.00 | ≈ $18.33 | Bus |
| $19.50 | $21.50 | $21.50 | Equal |
| $30 | $32.00 | $25.00 | Taxi |
Below $19.50 an hour, the bus has the lower full cost. Above it, the taxi does. The model leaves out comfort, safety, and the fact that you can read or rest on a bus, so bus time is not completely lost.
At $10 an hour, the bus wins easily. At $30 an hour, the taxi wins. The fares never changed. What changed was the opportunity cost of 40 minutes. This explains something you may have noticed: people whose time is very valuable, such as a doctor between two hospitals, often pay more to save time. They are not wasting money. Their time costs more.
Two students live on the same street and go to the same school. One takes a slow, cheap bus. The other pays more for a quick ride. Must one of them be making a mistake?
Show the answer
No. They may face different opportunity costs. If one student has a paid job after school, or a younger brother to collect, the minutes saved are worth more to that student. The same choice can be sensible for one person and not for another, because their next best uses of time are different.
Worked examples
Kwame can work at a café on Saturday afternoon for 3 hours at $9 an hour. Instead, he plays in a football match that lasts 3 hours. Working at the café was his next best choice. What is the opportunity cost of the match? (This example is invented.)
Think first. What is the next best alternative? Can it be measured in money?
His next best alternative is working at the café. It would have paid dollars. So the opportunity cost of the match is the $27 of pay he gives up.
Now change one fact. Suppose his next best choice was revising for a test, not working. Then the opportunity cost is 3 hours of revision. The café pay is not counted, because it was only his third choice.
Check. In each version, only one alternative is counted, and it is the one he ranked second. ✓
Priya is 16. She can stay at school for two more years, or leave now and take a job paying $800 a month. School costs $600 a year in fees and $150 a year in books. If she stays, what is the opportunity cost? (This example is invented.)
Think first. Count the money she pays, and the money she does not earn.
Money she pays: dollars.
Wages she gives up: dollars, for 24 months.
Opportunity cost of two more years: dollars.
Notice that the wages make up about 93% of the total. Most of the cost of school is not the fees at all.
Check. . ✓ This does not mean Priya should leave. Staying may raise her earnings for the rest of her life. But a good decision weighs that gain against the full $20 700, not against $1 500.
A town council has $5 million to spend. It can build a new wing for the hospital, or four primary schools at $1.25 million each. It chooses the hospital wing. What is the opportunity cost? (This example is invented.)
Think first. Here the next best alternative is a set of goods, not an amount of money.
The money buys schools. So the opportunity cost of the hospital wing is four primary schools that are not built.
This is how opportunity cost is usually measured in economics: in the goods that could have been produced instead. A later lecture draws a graph of these choices for a whole country.
Check. . ✓ The council spends the same $5 million either way. The real question is whether a hospital wing is worth more to the town than four schools.
The situation. In the 1990s, many poor families in rural Mexico took their children out of school after primary school, at around the age of 12 to 14. The money cost of school, such as uniforms and books, was only part of the problem. The bigger part was the opportunity cost. A teenager at school is not earning money or working on the family farm, and a poor family feels that loss sharply.
The policy. In 1997 the Mexican government started a programme called PROGRESA. It paid poor families a monthly grant for each child, on condition that the child attended school at least 85% of the time. The grant was larger in higher grades, and larger for girls in secondary school. It went from 60 pesos a month in the third grade to 225 pesos a month for a girl in the third year of junior secondary school.
The prediction. The grant lowers the opportunity cost of school for the family. Part of the lost earnings is now replaced. So economics predicts that more children will stay at school, especially at the ages when they could otherwise earn the most.
What happened. The government phased the programme in, starting with some villages chosen at random, out of 506 villages in the study. This allowed a fair comparison. Researchers Orazio Attanasio, Costas Meghir and Ana Santiago found that the programme raised school enrolment of 14-year-old boys by 14 percentage points. Their study appeared in the Review of Economic Studies (volume 79, 2012), and is summarised by the research centre J-PAL. It had no effect on 10-year-olds. Almost all of them were already at school, because at that age their opportunity cost was low.
Verdict. The prediction was right, and in the way opportunity cost says it should be. The programme worked best exactly where the opportunity cost of school was highest: in the early teenage years. Notice also what the low money cost of school had been hiding. A school place that costs a family little money can still be very expensive for it, because the biggest cost of school is often not money paid at all.
Three traps
The opportunity cost is only the next best alternative. If you could have had only one of the other choices, adding them all together counts things you could never have had.
A free ticket, a free ride or a free school place costs no money, but using it still takes time or other resources. Ask what else you could have done. That is the cost.
Suppose you paid $10 for a ticket last week, and you cannot get the money back. Today you are deciding whether to go. The $10 is gone whether you go or not, so it is not part of today's opportunity cost. Economists call money like this a sunk cost. Only what you would give up from now on belongs in the decision.
Work each one on paper first. Open a hint only when you are stuck.
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Aisha has a free evening. Her first choice is to revise for a test, her second is to watch a cricket match on television, and her third is to cook dinner with her family. She revises. (a) What is the opportunity cost of revising? (b) The match is cancelled before the evening starts. What is the opportunity cost of revising now?
Hint 1
Find her second choice among the things she could actually do.
Hint 2
In (b), the match is no longer possible. Move down her list.
Full answer
(a) Watching the cricket match, her next best alternative. (b) Cooking dinner with her family, because the match is no longer an alternative. Check: in each part exactly one alternative is named, and it is the best one still possible. ✓
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Diego is given a free cinema ticket for Sunday afternoon. He cannot sell it, and $12 is printed on it. His next best choice is to babysit for 4 hours at $7 an hour. What is the opportunity cost of going to the cinema? Explain why the answer is not $12.
Hint 1
What does Diego give up by going to the cinema?
Hint 2
Work out the babysitting pay. Then ask whether Diego could ever have had the $12.
Full answer
He gives up babysitting, which pays dollars. So the opportunity cost is $28 of pay. It is not $12, because Diego never had that money and cannot sell the ticket to get it. The $12 was paid by someone else. Check: the answer names one alternative, his next best, and it is measured in the pay he gives up. ✓
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A bus costs $3 and takes 50 minutes. A taxi costs $18 and takes 20 minutes. For what value of an hour do the two choices have the same full cost? (These prices are invented.)
Hint 1
How much extra money does the taxi cost? How much time does it save?
Hint 2
The taxi costs $15 more and saves 30 minutes. Find the value of an hour that makes 30 minutes worth $15.
Full answer
The taxi costs dollars more and saves minutes, which is half an hour. The two choices cost the same when half an hour is worth $15, so when an hour is worth $30. Check: at $30 an hour, the bus costs dollars in full, and the taxi costs dollars. ✓
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Mei and Kofi are making things to sell at a school fair. In one hour, Mei can make 6 cakes or 2 scarves. In one hour, Kofi can make 4 cakes or 2 scarves. (a) Find the opportunity cost of one scarf for each of them, in cakes. (b) The fair needs 2 scarves. Who should make them, so that the pair gives up the fewest cakes? (This example is invented.)
Hint 1
For Mei, 2 scarves cost the 6 cakes she could have made in the same hour. Divide to find the cost of one scarf.
Hint 2
Compare how many cakes are given up if Mei spends an hour on scarves, and if Kofi does.
Full answer
(a) Mei: 2 scarves cost 6 cakes, so 1 scarf costs cakes. Kofi: 2 scarves cost 4 cakes, so 1 scarf costs cakes. (b) Kofi should make the scarves. If Kofi spends an hour on scarves, the pair gives up 4 cakes. If Mei does it, the pair gives up 6 cakes. Check: Kofi's cost per scarf, 2 cakes, is lower than Mei's, 3 cakes, and is less than . ✓ Notice that Mei is better at making cakes, yet the job still goes to the person with the lower opportunity cost. Economists call this comparative advantage. It is the main reason people, firms and countries trade.
The idea is old, but the name is young. Writers such as Benjamin Franklin used the reasoning in the 1700s. The term "opportunity cost" first appeared in 1894, in an article by the American economist David I. Green in the Quarterly Journal of Economics. Green argued that most of what we call the cost of something is the sacrifice of the other opportunities we could have taken.
Seeing opportunity cost changes how you think about every decision. A price tag shows only the money. The real question is always: what is the best thing I am giving up? A student choosing a subject, a family choosing a home and a government choosing between a hospital and four schools all face that same question. Each of these choices uses resources such as land, workers and machines, which could have been used for something else. The next lecture looks at those resources one by one.
- The opportunity cost of a choice is the next best alternative that is given up when the choice is made.
- Only the next best alternative is counted, because a person could only ever have had one of the other choices.
- Opportunity cost is a thing given up, such as time, a meal or a wage, and it can be measured in money only when the thing given up has a money value.
- Something that is free to you, such as a free ticket or a free school place, still has an opportunity cost when it uses your time or other resources.
- Money already spent that cannot be recovered, a sunk cost, is not part of the opportunity cost of a decision made now.