Marshall and Shackle on opportunity cost

by on September 5, 2005 at 6:13 am in Economics | Permalink

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.

Mike September 5, 2005 at 10:44 am

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.

Mike September 5, 2005 at 11:18 am

Sorry – the first sentence of that last paragraph makes no sense. I should have deleted it.

Matt September 5, 2005 at 12:08 pm

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.

radek September 5, 2005 at 3:09 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.

Matt September 5, 2005 at 7:25 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.

Seamus Hogan September 5, 2005 at 10:07 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.

Joe O September 6, 2005 at 2:38 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.

Matt September 6, 2005 at 8:58 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)

radek September 7, 2005 at 1:28 am

It’s obviously a round trip bus ticket, what else?

Eric Larson September 12, 2006 at 11:43 pm

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.

Comments on this entry are closed.

Previous post:

Next post: