Alternative University

Economics

Opportunity Cost

Opportunity cost in economics is the cost of not having taken a better choice:

“The concept of opportunity cost is commonly used in economics; it is measured by reference to the opportunities foregone at the time an asset or resource is used”
— 
OECD Glossary of Statistical Terms
“Calculation of the costs according to the opportunity cost principle is based on the alternative usage of the production factors. According to the opportunity cost principle, the costs are equal to the earnings lost (lost opportunity) by not using the production factors in question in the best alternative way. The opportunity cost principle is the key basis for all economic planning (a cost concept pointing to the future).”
— 
Svend Rasmussen, Production Economics, p. 56

Opportunity cost is the cost difference of different choices. That is the definition we refer to here. Another definition, used in accounting, refers only to the cost of an alternative not chosen. That is covered in James A. Buchanan, “opportunity cost”, The New Palgrave Dictionary of Economics. Either way, opportunity cost occurs when a decision is made:

“opportunity cost exists only at the moment of decision when choice is made. It vanishes immediately thereafter. From this it follows that cost can never be realized; that which is rejected can never be enjoyed.”
— 
The New Palgrave Dictionary of Economics

The unchosen opportunity is lost forever. What may be portrayed as choosing the unchosen opportunity later is actually choosing a different opportunity that may not be as efficient or even possible (for example, skilled persons and businesses — intellectual assets — having switched to a different skill and no longer available, etc.).

Compound opportunity costs depend on (are caused by) previous opportunity costs, and are also called cascading opportunity costs or reverse multiplier effect.

“ ‘The big question is the opportunity cost,’ Caleb Watney at the Progressive Policy Institute told me. ‘Congress likes to pass a big, flashy bill and cross it off the list and not think about the issue for another five years.’ ”
— 
German Lopez, “How Congress wrecked its own science bill”, 4 June 2021 [Vox]

Comparative Advantage

Consider running a business in a composite good industry o (of firms with complementary intellectual assets). Say you need to hire out (outsource) some of the firm’s innovative work in order to produce more output, for example if time or resources are limited. Not outsourcing some of the work would reduce your production output, falling below minimum production necessary to stay in the composite good industry.

Further assume that, of the different innovative tasks which could be outsourced, you can do those tasks yourself more efficiently (e.g., at lower cost) compared to outsourcing, but (as mentioned) there is not enough time or resources to do all of those tasks yourself.

The question is: what do you choose to outsource? Outsourcing any of those tasks would be more costly than doing the task yourself, but not as costly as doing it all yourself and falling out of the composite good industry.

The answer is to choose the lower opportunity costs. The highest opportunity cost would be to fall out of the composite good industry, so that would be your last choice. Next you go through the tasks that can be outsourced, and choose to oursource those that incur less opportunity costs than other tasks.

Your main intellectual asset would have the highest opportunity cost to outsource (because a composite good industry reformulates until that is so for each firm). So you would go through other tasks, to find ones to not do in-house.

This concept, called comparative advantage, extends to trade between societies (that have different money supplies — international trade). The idea is to perform the more valuable work in-house or in-society, while outsourcing the relatively less valuable work that you could still do more efficiently in-house or in-society and is high value but not as high value as your core work.

That is the basic idea of comparative advantage. Economics is a multi-dimensional science, and many factors affect comparative advantage in general. For example, a changing market could affect the composite good to require you to switch to a different core competency in the future, causing you to plan to phase out your core work eventually, providing incentive to outsource it even if it is (temporarily) higher value. Likewise, an innovative task that is less valuable now may be destined to become more valuable in the future, creating incentive to not outsource that one, in order to better train and ramp up for the future.


References

 1.  Kowalski, P. (2011-10-05), “Comparative Advantage and Trade Performance: Policy Implications”, OECD Trade Policy Papers, No. 121, OECD Publishing, Paris. pdf


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2021–Aug–2  10:07  UTC