Category: General Interest

What is Opportunity Cost?

If there is any single purpose to the study of Microeconomics, it is to answer the question of how society and individuals make decisions when facing scarcity.  Whether it be natural resources, money, or simply available time, scarcity forces us to forgo what would otherwise be attractive opportunities.  I’d like a new car, but I need to save to make repairs to the house.  I’d like to go back to the coast but need to finish some projects at work.  And I kind of wanted to sleep in this morning, but I also wanted to write a bit before work.

Opportunity cost is that which is foregone when we make a decision.  And so, a new car, returning to the coast, and sleeping in this morning are all opportunity costs. 

AP Photo David Zalubowski

But, and this is important, opportunity cost is THE forgone alternative that would have been selected otherwise, not EVERY possible alternative.  For example, when I bought my last car, I chose the color Kona Coffee.  I could have selected red or white or blue or several other different colors.  So, what was the opportunity cost of having a fancily named dark brown car?  I couldn’t also drive a blue car or red car or white car etc.  But what would I have driven?  I really liked the Pearl White.  And so, the opportunity cost of choosing the brown wasn’t blue.  I don’t particularly like blue cars.  I wouldn’t have purchased a blue car regardless.  For me, the opportunity cost of the brown car was not choosing the white one.

Another thing to be careful of when thinking about opportunity cost is to avoid irrelevant costs.  The weather is pleasant today and so I may decide to walk into the office.  What would be the opportunity cost of doing so?  Getting a little less work done today.  Walking will take about forty extra minutes (including both this morning and then back home this afternoon).  But I have a Kona Coffee (dark brown) car sitting out front.  What about the money I spent on that, and the cost of insuring it and the taxes they’ll charge me?  Obviously irrelevant.  I have to pay those whether I walk or not. 

But people do this all the time – erroneously.  “I really don’t want to go to the concert tonight.   They’re doing a David-Tennant-as-Doctor-Who marathon tonight and I’m exhausted and just want to stay home.  But I paid $50 for those tickets and so I have to go.”  “But” nothing.  You’re out the $50 whether you or you don’t go.  It’s irrelevant.  If there’s any opportunity cost involved, it’s the opportunity cost of dealing with the regret of having paid for the tickets.  That’s guilt.  If it’s running your life, maybe get counseling.  But don’t let it distort your decision making.  Focus only on those things you truly forgo, your opportunity costs.

What is Comparative Advantage?

Sarah is an accomplished typist.  On a good day she can type close to 200 words per minute.  Sarah is also a successful attorney who runs her own small legal practice.  By providing legal services, she generates, on average, about $250 per hour.  Sarah is considering hiring Andrea as a personal assistant.  Andrea would be responsible for all the non-legal aspects of running the office, mostly reception, filing, and typing.  But unfortunately, Andrea is not a particularly strong typist.  She can only type 100 words per minute.  Should Sarah hire Andrea to help out or continue to do the typing and other tasks herself?

hands typing
Courtesy of Udemy.com

Sarah has what economists refer to as an “Absolute Advantage” in typing.  All else equal, she is capable of producing more typed work per hour than Andrea.  But, that doesn’t mean Sarah should continue to do the typing.  Her “opportunity cost” of typing is simply too high.  For example, assume that a large number of adjustments need to be made to a legal brief.  To retype the document will take Sarah a full hour.  Of course it’d take Andrea two hours.  But what’s the opportunity cost of an hour of Sarah’s time?  Assuming she has sufficient opportunities, she could provide her legal expertise during this hour and generate additional income of $250.  So, the opportunity cost of her doing the typing is the foregone $250.  On the other hand, she can hire Andrea for $20 an hour.  While it will take longer for Andrea to type the legal brief, the out of pocket expense is only $40 which is considerably less than the implicit cost of $250 Sarah must incur if she does it herself.

So, while Sarah has the Absolute Advantage, Andrea has the “Comparative Advantage”.  By that we mean Andrea has the lower opportunity cost of typing.  Sarah’s law practice gives up less if it hires Andrea and leaves Sarah free to practice law. 

We know Andrea’s wage is lower than Sarah’s but how do we know that Andrea has the lower opportunity cost?  Does a lower wage somehow imply lower opportunity cost?  In a free market economy with free mobility of labor, the answer is a qualified yes.  We can assume that if Andrea had the opportunity to earn more elsewhere for equally attractive work, she would either elect to take that job instead or demand a higher than $20 wage from Sarah.  So, in effect, we are assuming that the $20 represents an upper bound on Andrea’s opportunity cost.

Not only wages, all resources costs are assumed to represent some upper bound on the opportunity cost of the resource in its next best use.  For example, why is it necessary for Sarah to pay rent for her office space?  Because the owner of the office building might be able to rent the office to someone else, perhaps an accounting firm.  And what if this accounting firm was willing to pay $1,000 a month in rent?  Would the owner of the building want to charge Sarah $750?  No.  All else equal, we assume the owner would charge her at least $1,000 – that is, enough to cover his opportunity cost of letting her use the space.

This is a fundamentally important foundation in the understanding of market economics.   From society’s standpoint is it better to use a mechanical engineer or an auto mechanic to repair a car?  While they both may be capable, the opportunity cost to society of using the engineer is greater.  While she’s fixing the vehicle, she isn’t designing newer more efficient alternatives.  The opportunity cost for the mechanic is less.  And so, society is better served to let the mechanic do the repairs and have the engineer do more valuable work.

The beauty of markets is that they align the interest of decision makers with this concept.  If I run an auto repair shop, I’m likely not going to hire mechanical engineers.  Not because I read about Comparative Advantage, but because mechanical engineers are more expensive to hire.  The engineer can demand a higher wage than the auto mechanic because the “market” deems the value of what they’d forgo more highly.  And so, anyone seeking to hire them must compensate them for the corresponding higher foregone wages.

Comparative Advantage and International Trade

A common application of the concept of Comparative Advantage is in explaining why nations trade.  Consider the United States and Bangladesh.  Bangladesh is a developing economy in southern Asia.  It has a population of over 150 million with GDP of only around $2,000 per person.  The United States on the other hand, has a population double that and GDP per person 25 times greater.  Given both the larger population and size of the economy in the United States, how can the United States derive any benefit from trading with Bangladesh?

Courtesy of businessinsider.com

While the United States does have the absolute advantage in producing almost all possible products, Bangladesh still has the comparative advantage in many.  Remember the example we began with; Sarah like the United States was better at both typing and providing legal services.  But it still made sense for Andrea to do the typing because her opportunity cost was lower.  Likewise, if the United States were to reallocate resources to the production of garments and other labor-intensive goods, it would necessarily produce fewer high value-added products.  Bangladesh on the other hand doesn’t give up these high value-added products when it produces garments.  And so, just like with our opening example, it makes sense for Bangladesh to produce garments freeing up US resource to produce high-value capital and technology intensive products.

And again, the market system recognizes this.  If I were to open a factory here in the US producing inexpensive sunglasses, I’d have to pay my workers $10 to $15 per hour.  The (relatively) high wage would be necessary to compete these workers away from other valuable activities.  Technically, I’d have to pay them enough to cover their opportunity cost.  Whereas in Bangladesh, I could pay them $2 to $3 an hour.  Why?  Because they have fewer opportunities for alternative employment – at least employment that could pay well.  Their opportunity cost is lower.  And so, it is much more profitable for me to produce my sunglasses in Bangladesh than in the United States.

Comparative Advantage as the Underpinning of Industrialization

While Adam Smith is generally credited with laying out the case for market directed industrialization.  It is really the concept of comparative advantage, later developed by David Ricardo (1772-1823), which must underpin our understanding of contemporary industrial economics. 

A non-industrialized economy is one based on self-sufficient participants producing for themselves some broad basket of subsistence goods.  Adam Smith described (but failed to completely justify) how, by specializing in the production of some particular good and then trading with others for other needed goods, all involved could enjoy a much-increased standard of living. 

But now understanding the concept of comparative advantage, we realize that markets incentivize producers to minimize cost and that cost minimization is based on the concept of comparative advantage.  And so, a working definition of an industrialized society is one where participants organize their activities according to comparative advantage and rely on trade to meet their broader needs.