Economics 103
Lecture # 8
Opportunity Cost
• What is Cost?
- this is one of the most useful ideas in economics
but it is one of the least understood.
The most common notion of cost is … historical cost.
In economics we don’t use this notion of cost.
We don’t use it because often it is irrelevant
for behavior.
In each case, the historical price is completely
irrelevant for how you behave now.
In Economics cost is often called Opportunity Cost to
highlight the difference with historical cost.
Costs depend on the alternatives you face.
“My wife and I decided we could either have
a vacation or a divorce. We chose a divorce
because a vacation only lasts a week, but a
divorce can last a lifetime.”
Why would a loaf of bread cost
$1.35? What does that mean in terms of
opportunity cost?
How much does it cost to make, eat, sell a hamburger
To figure out the cost of the next best alternative, you may need to
add some costs up.
But you have to wait in line for
10 minutes. Should this be part of the
cost?
If student’s don’t like tuition increases
…
Don’t confuse Costs with Bads.
A swimming pool has lot of good
things about it …
but it also has some bad
things.
The cost of the pool is the value of the next best alternative.
For example a really nice band saw.
A nice understanding of Opportunity Cost:
Friedman vs. ??
The Broken Window Fallacy
Cost Questions:
1. You find a diamond in your back yard worth $4000. You decide
to put it in a ring for $1000 and keep it. Did keeping the ring
cost you $1000?
2. You buy a ticket for Supertramp for $150. At the gate a scalper
offers you $300 to buy the ticket. You turn it down. Did it cost
$150 to see the band?
3. You own a art shop and you’ve bought a painting for
$3000 and plan to sell it for $6000. Before you sell you find
out the artist has just died, and his work is now selling
wholesale for $5000. People are phoning you asking
about the painting. Will you act as if the painting cost you
$5000?
4. Why would a volunteer army cost less to a society than a draft
army?
More Cost Questions.
1. If it rains, is it more costly to use self-serve pumps?
2. If I hate doing the weeding, but my wife loves it, is it more
costly for me to do it?
3. Does it cost more for a surgeon to operate on a poor person?
4. Are costs for a store higher if it owns or rents its space?
5. If Costco comes along and offers to rent the store space, did
the store’s costs increase?
-if costs increase, is this a bad thing?
- costs are not the same as bads.
Still More Cost Questions
1. If you inherit something, does it cost to use it?
2. What’s wrong with this conversation:
“Boy, there’s never anyone in this club”
“It doesn’t matter, the owners own the building and don’t have
to pay rent.
3. What’s wrong with this conversation:
“I wonder what he needs to charge to make a profit.”
“That depends on how much of a downpayment he made.”
4. Who sleeps more: high or low wage people?
-teenagers, Nygard case, Lottery winners.
One Last Cost Question:
Movie breaks at Schindler’s List …. I get a coupon
Flight is delayed from Montreal … I get another flight.
I take back a toaster that doesn’t work … I get my money back.
What is going on?
Some actions involve expenditures that have no salvageable option.
Non-salvageable costs are called sunk costs
More Sunk costs examples:
Movie about terrorism.
Scheduled release:
October 2001.
Cost $70 million, but
was not released.
Aside from the distinction between Sunk and Ordinary Costs, costs
might be either variable or fixed.
Costs can be any combination of fixed/variable vs Sunk and
Ordinary.
Suppose you own a Comic Book Store. What examples of
costs would fit into the matrix below?
Heat in the reading
room
Custom made
sign outside.
Comic books bought
from the wholesaler
“special” pin given
away with every
purchase.
We are going to assume that all fixed costs are sunk, and all
variable costs are ordinary costs.
Airlines don’t charge you for pop like they do for booze. Can that
explain why it is so hard to get:
The distinction between Sunk and ordinary costs is important
because behavior depends on ordinary costs, not sunk costs.
Suppose you are a TV retailer and you buy 28 sets for $19600, and
as a result you win a free two week trip to Las Vegas. After you get
back you find out you can’t sell one TV. The TV’s would sell for
$5600 as junk, and an orphanage has offered $20,000 for the works.
You wonder what your costs are:
Wholesale costs …. $19600.
Interest for 1month … $196
Handling
… $2000
Advertising ….
$800
Display Space … $1400
Total:
$23,996
Since its bad business to sell
below costs, you turn the
orphanage down.
Did you make the right
decision?