If you didn’t see the first post on opportunity cost, you need to read that first. It is here.
For those of you who have read that post, let’s continue…
If you remember, in part 1 of this article, I asked you to 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.
What is the opportunity cost of attending the Clapton concert?
The correct answer is £10.
A few people answer a) £0. Now it’s certainly true that since you haven’t paid for the Clapton concert, it is costing you nothing in monetary terms. The argument that you haven’t yet bought the Dylan ticket and so there is no cost involved in having wasted your money isn’t actually correct. Why not? Because if you _had_ bought the ticket and you couldn’t refund it, that cost becomes irrelevant because there is nothing you can do about it. The correct term for this in economics (and business) is a ‘sunk cost’.
Other people go for £50, and they’re closer, but not quite right.
We’ve established that the opportunity cost of something is what you have to give up to get it. In this case, you have to give up the Dylan concert to see Clapton. How much is the Dylan concert worth to you? The clue is in the question. You would normally be prepared to spend “up to £50” to see Bob Dylan in concert. So if I offered you a choice of £10 or seeing Bob, you’d go for Dylan every time. If the choice was £40 or Dylan, you’d still go to the concert. If the choice was £60 or Dylan, you’d go for the £60. The tipping point at which you are indifferent between the cash and Bob Dylan is £50.
So why is the answer not £50 then?
Well don’t forget that the Dylan tickets cost £40. By choosing to go to see Eric Clapton, you lose out on a Bob Dylan concert that you value at £50. But, since the Clapton ticket is free and the Dylan ticket is £40, you also save yourself £40. That’s a £50 negative and a £40 positive effect from going to the Clapton concert – in other words an opportunity cost of £10.
I have seen it argued that surely it must depend upon the value you place on seeing Eric Clapton in concert as well as the value of seeing Bob Dylan. That’s definitely thinking along economic lines, but it’s not actually correct. What the question is asking is the opportunity cost of seeing Eric Clapton – the question is not whether you should see Clapton or Dylan.
Let’s use a simpler example to illustrate this point. You are hungry enough to eat precisely one small meal. A kindly passer-by offers you a choice of two small meals for free* – white truffles and caviar (which normally you would be happy to pay up to £100 for) and a packet of salt & vinegar flavour crisps (which you’d normally be prepared to pay up to 60p for). You get only one of these meals. The opportunity cost of having the crisps is £100 – the value you put on the truffles and caviar you have forgone. Conversely the opportunity cost of the truffles and caviar is 60p – the value to you of the crisps forgone. You’ll clearly choose the truffles and caviar, but notice how the opportunity cost of them would still be 60p if you valued them at £1million.
* Of course, as students of economics and classic science fiction well know, “There Ain’t No Such Thing As A Free Lunch”. Well, in this simplified thought experiment, there is.