Important Economics Concepts Every Businessman Should Know, Number 1: Opportunity Cost

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Let’s say you pay your office cleaners £20 to clean the office each night. You could actually clean the entire office yourself and you wouldn’t have to pay anyone £20, just a few quid on cleaning consumables, dusters etc. Now you know that the reason you don’t is because it would take you a couple of hours to do it, and if you were to spend an extra two hours a day at work, there are far more useful and lucrative things you could be doing with your time. So while the cost of you doing the cleaning should take into account the £20 you’re saving by not paying the cleaners, it also needs to take into account the profit the company would have made but now won’t see on the extra sales that you would have made with an extra couple of hours in the office. That, in a nutshell, is what opportunity cost is all about.

 

Consider this scenario:

You’ve just won a ticket to see Eric Clapton in concert tonight. You can’t resell the ticket. The only other thing you might want to do tonight is see Bob Dylan in concert. Assume that both concerts are the only gigs each performer is playing that you could get to in the foreseeable future.

The Dylan ticket costs £40. You quite like Bob Dylan, and normally, you would be prepared to spend up to £50 to see a Dylan concert. If Dylan tickets cost more than £50 you would think that too expensive and you wouldn’t go even if you had nothing else to do.

Opportunity cost is one of the most vital concepts in economics. Put simply, the opportunity cost of engaging in an activity is the value of everything you must give up in its place.

Now try to answer this question. This isn’t one of those questions that “has no right or wrong answer”. There is a correct answer. It looks like a simple question. However, if I told you that a recent academic study showed that only 7.4% of university students who had previously taken a course in economics got the right answer, you might appreciate that it’s somehow not quite so simple. Strangely, 17.2% of undergraduates who had never studied economics got the right answer. (My own experience of posing this question supports these results.) Perhaps most bizarrely, only 21.6% of 199 professional economists sampled got the question right! Think about it, if you just guess, you’ve got a 25% chance of getting it right.

What is the opportunity cost of attending the Clapton concert?

a)      £0

b)      £10

c)       £40

d)      £50

For the answer, you’ll have to wait for my next post.