Dissecting the Concept of Opportunity Cost

Perhaps no topic is really simple, if you look at it closely. In the Winter 2016 issue of the Journal of Economic Education, a group of five economists put the intro-year topic of "opportunity cost" under a definitional microscope. The JEE is not freely available online, but many readers will have access through library subscriptions.

David Colander provides an introduction. Michael Parkin provides a brisk overview of the history of thought about opportunity cost, and argues that opportunity cost is more usefully based on the quantity of what is given up, rather than on attempts to calculate the value of what is given up. Daniel G. Arce, Rod O’Donnell, and Daniel F. Stone offer critiques. Parkin then seeks to synthesize the various views by arguing that opportunity cost as value can be interpreted in several different ways, and claims that one of these interpretations reconciles his view with the critics.

Parkin's first essay is full of interesting tidbits. For example, I had not known that the concept of opportunity cost dates back to an essay in the January 1894 issue of the Quarterly Journal of Economics called "Pain-Cost and Opportunity-Cost" (8: 2, 218-229). This reference sent me scurrying to the JSTOR archive, where I find that David I. Green starts off in a discussion of the true cost of labor, before moving to a more general argument:

But what is commonly summed up in the term "cost" is not principally the pain or weariness on the part of the laborer, and of long delay in consumption on the part of the capitalist; but the costs consists for the most part of the sacrifice of opportunity. ... By devoting our efforts to any one task, we necessarily give up the opportunity of doing certain other things which would yield us some return; and it is, in general, this sacrifice of opportunity that we insist upon being paid for rather than for any pain which may be involved in the work performed. ... But when we once recognize the sacrifice of opportunity as an element in the cost of production, we find that the principle has a very wide application. Not only time and strength, but commodities, capital, and many of the free gifts of nature, such as mineral deposits and the use of fruitful land, must be economized if we are to act reasonably. Before devoting any one of these resources to a particular use, we must consider the other uses from which it will be withheld by our action; and the most advantageous opportunity which we deliberately forego constitutes a sacrifice for which we must expect at least an equivalent return.

But Parkin's main focus is more on the concept than on the history. He writes:

The idea of opportunity cost helps to address five issues that range from the simple and basic to the complex and sophisticated. The simplest and most basic purpose of opportunity cost is to express the fundamental economic problem: Faced with scarcity, we must make choices, and in choosing we are confronted by cost. The second purpose, equally basic, is to see cost as an alternative forgone rather than dollars of expenditure. Its third purpose is to identify, and to correctly establish, what the forgone alternative is. Its fourth purpose is to use the appropriately identified cost alongside an appropriately identified benefit to make (and to analyze) a rational choice. Its fifth purpose, and its most complex and sophisticated, is to derive theorems about the determination of relative prices.

He gives examples from the 1920s and 1930s up through modern textbooks to illustrate that while some writers have preferred to think of opportunity cost in terms of quantity foregone, others have preferred to think of value foregone. He writes:

The two definitions of opportunity cost (hereafter OC) differ in what is forgone. For the “quantity” version, it is the highest-valued alternative: the physical thing or things that otherwise would have been chosen. For the “value” version, it is the value of the highest-valued alternative: the value of the physical thing or things that otherwise would have been chosen.

Parkin argues  that the quantity measure is most useful, in part because using "value" adds an additional and potentially controversial step to the concept. 

Daniel Arce argues that value-based calculations of opportunity cost are useful in certain contexts, like looking at shadow prices or deriving a measure of economic profit. Along the way, he makes the interesting claim that teaching and learning about opportunity cost suffers less from imprecise definition than from lack of good old-fashioned examples. Arce writes:

In over 25 years of teaching principles of economics, I have used at least 10 different textbooks and cannot recall a single student expressing concern that the textbook’s treatment of opportunity cost was ambiguous, nor have I had any difficulties with how opportunity cost is operationalized in the associated test banks.What I have had trouble with is the dearth of examples in textbooks and test banks. Opportunity cost is a major takeaway in principles of economics and in managerial economics for MBAs. Yet, I can think of no textbook in either area in which the coverage of opportunity cost would sustain even half a lecture. With consulting firms earning millions of dollars calculating economic profits for their clients (where the hard work is in identifying opportunity costs), how can this be? This is compounded by the virtual absence of any discussion of opportunity cost in undergraduate and MBA textbooks’ coverage of marginal decision making (e.g., utility maximization, cost minimization, and profit maximization) and a similar lack of material on marginal decision making when opportunity cost is covered. 

Rod O'Donnell and Daniel F. Stone offer further arguments in favor of the value criterion: for example, that it is especially useful in talking about interest rates (or foregone rate of return) as an opportunity cost, and that using value terms for opportunity cost offers an advantage of making comparisons across similar units.

Parkin argues in his closing essay that the "value" approach to opportunity cost can be divided into two approaches as well: 

For the “value” version of OC, what is forgone is the highest amount that would be willingly paid for the forgone alternative. Value is willingness to pay. ... Another commonly used value concept is the number of dollars thatmust be paid at market prices to buy a defined basket of goods and services. ... For the “quantity” version of OC, it is the physical basket (not its dollar value) that is the defining feature. The dollars are merely a convenient measuring rod. To be clear, for the “value” version of OC, the dollars represent the largest amount that would be willingly paid, while for the “quantity” version of OC, the dollars represent the amount that must be paid.

Parkin argues that with this distinction in mind, all the writers are in agreement. I suspect the other writer would not agree with this assessment! But I'd like to add my agreement to Arce's point that opportunity cost is a powerful idea that gets short shrift in the classroom, both because it is less tied into other concepts than it could be, and also because it lack a wide range of strong examples that help give students a sense for its many applications.