Wednesday, October 26, 2005

Opportunity Cost - Economic Reasoning #1

Apparently, one of THE most important concepts central to economic reasoning.

The following question was asked at the 2005 Allied Social Sciences Association conference in Philadelphia, of whom 61% had taught an introductory economics course. Read more here.

You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50.

And about 78% of them answered it incorrectly!

"Opportunity cost stresses the relationship between the act of choice by the decision-maker and opportunities foregone. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed."

Seems simple! If you have chosen a, c, or d, then you are wrong!
One must consider both benefits and costs of alternate activities. So the answer is $10.

Now answer this! [from Catallarchy]

John owns a retail consumer electronics business. He sells ten 30 inch plasma TV sets per month. His wholesale price is $2000, his markup is $1000 and his selling price is $3000.If he takes a set home for use in his den, which of these dollar amounts, if any, is his approximate sacrificed opportunity cost. Explain your reasoning.

And here the concept is seen in richer detail. Steven Horwitz and Will Wilkinson provide the most convincing answer for it.

"The opportunity cost of the decision to keep the TV for himself is the foregone expected utility from his next most preferred choice. True opportunity cost cannot be measured - it is subjective. Read Buchanan’s Cost and Choice for the full argument.
And money and utility are NOT the same thing. We can make the assumption that money/income are what we’re measuring as opportunity cost, but true opportunity cost is foregone utlity not money. If you want to work with money, you need to, as many folks have said, precisely define the moment of choice. If the TV has already been bought for inventory and he decides to take it home, he forgoes $3000 for that choice. It’s either “keep it” and enjoy the utility stream from it or “sell it” and have $3000 more in hand than otherwise. If he chooses to buy one at wholesale and keep it, then the moment of choice is the purchase at wholesale price, in which case the opportunity cost of keeping the TV is his next best use of the $2000.Cost is always at the moment of choice. (It’s also always subjective and about expectations, but here we’re staying with money.)"

Why is all this important? Ask a businessman who has employed a well trained economist!

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