Principles of Economics – Opportunity Cost & Related Concepts

Scarcity and the Necessity of Choice

Because resources (time, money, energy) are limited, individuals and societies face scarcity. Scarcity forces choice: every time we choose one option we must give up others. The value of what we forgo is the opportunity cost (OC).

OC = \text{Value of the next‐best alternative forgone}

Choosing rationally therefore requires that decision-makers compare the expected benefit of an action with its associated opportunity cost.

Visualising Simple Trade-offs (Work vs. Relax)

• A binary illustration shows that a person cannot simultaneously work and relax; taking one action excludes the other.
• Even in this simplest case, the unseen cost of relaxing is the wage (or output) sacrificed, while the unseen cost of working is the rest sacrificed.

More than Two Choices: Ranking and the “Next Best Alternative”

When there are multiple mutually exclusive options, only the single best rejected option counts in the OC calculation. Consider four students ranking three mutually exclusive ways to spend the next hour:

Active-learning MCQ for Gemma gave options (A)–(E). Correct answer: B — “Gemma cannot sleep for an hour.” It emphasises that the second-ranked activity, not the sum of all rejected activities, constitutes the OC.

Two Categories of Cost

1. Explicit Cost
   • Requires a monetary outlay.
   • Examples: buying a book, paying tuition, purchasing a 6 cup of coffee.

2. Implicit Cost
   • Does not involve an observable payment of money.
   • Reflects sacrificed alternatives that could have generated value (time, foregone wages, comfort).
   • Example: the extra hour of sleep you skipped to attend an early lecture.

Opportunity cost combines both categories:

OC = \text{Explicit Cost} + \text{Implicit Cost}

Coffee Example Revisited

• Paying 6 for coffee is an explicit cost.
• If the coffee purchase also means standing 10 minutes in line instead of working, the lost wage for those 10 minutes is the implicit portion.

Calculating Full Opportunity Cost: Simon’s Culinary Course

Scenario data:
• Tuition: 16{,}000 (explicit)
• Living expenses while studying: 7{,}200 (explicit)
• Textbooks: 500 (explicit)
• Forgone wage if not studying: 18{,}000 (implicit)
• “Baseline” living cost if working: 3{,}000 (implicit reference)

Step-wise breakdown:

1. Explicit Cost
   EC = 16{,}000 + 7{,}200 + 500 = 23{,}700
2. Incremental Living Cost
   7{,}200 - 3{,}000 = 4{,}200 (implicit)
3. Forgone Wage
   18{,}000 (implicit)
4. Total Implicit Cost
   IC = 4{,}200 + 18{,}000 = 22{,}200
5. Total OC of attending
   OC = EC + IC = 23{,}700 + 22{,}200 = 45{,}900

Interpretation: Simon should enrol only if the perceived net benefit (expected raise in lifetime earnings, personal satisfaction, etc.) exceeds 45{,}900.

Sunk Cost

Definition: a cost that has already been committed and cannot be recovered. Sunk costs are irrelevant to current marginal decisions; only future costs and benefits matter.

• Example: Duke Power’s cancellation of the Cherokee nuclear plant after spending 633 million (over 30 % of pre-cancellation net worth). Even though the funds were massive, they were unrecoverable and therefore sunk.
• Everyday illustration: the non-refundable movie ticket you bought yesterday. Whether you attend the movie tonight should depend on whether the enjoyment outweighs alternative uses of time now, not on the money already spent.

Distinguishing Sunk Cost from Opportunity Cost

• Sunk cost: lies in the past; ignore for future choice.
• Opportunity cost: lies in the future; must be weighed when choosing among current alternatives.

Real-World OC Computation: Ali’s Vacation Detour

Data:
• Travel cost per km (petrol + tolls): 5
• Already driven: 300 km (irrelevant; sunk once spent).
• Additional distance to attraction: 20 km.

Opportunity cost of the detour:
OC = 20\,\text{km} \times 5\;\$/\text{km} = 100

MCQ answer: 100. The 1{,}500–1{,}600 figures incorrectly include the sunk 300 km.

Connections to the “Thinking Like an Economist” Theme

1. Principle of rational decision-making: weigh marginal benefits against marginal opportunity costs.
2. Principle of ignoring sunk costs: past, unrecoverable expenditures should not distort current rational choices.
3. Principle of scarcity: because we cannot have everything, trade-offs permeate all decisions—from personal time management to billion-dollar corporate investment.

Practical Implications and Ethical/Philosophical Reflections

• Ethical budgeting: Firms should avoid “throwing good money after bad” when sunk costs cloud judgment (nuclear plant example).
• Personal well-being: Acknowledging implicit costs reminds individuals that time and energy are as valuable as money; work-life balance decisions hinge on unseen trade-offs.
• Public policy: Governments should perform cost-benefit analyses that incorporate both explicit budgetary outlays and implicit citizen impacts (e.g., commuting time, environmental degradation).

Key Takeaways

1. Opportunity cost equals the value of the next best alternative forgone; it includes explicit and implicit components.
2. Only the single best rejected option counts—do not sum every rejected alternative.
3. Sunk costs are historical and should never influence present or future decisions.
4. Correct economic reasoning ("thinking like an economist") demands consistently separating sunk costs from opportunity costs while making choices under scarcity.