A “three-minute” lecture on opportunity cost Edward R. Morey Draft: August 26, 2014 Put too simply, opportunity cost is your second choice (what you would have experienced if your first choice had not been available. Opportunity cost seems like a simple concept, but it is not. Many people don’t quite understand, including some graduate students. Hopefully all of the T.A.s in our class understand it. On the table are 4 packages of goods (A, B, C, D) I will often call them bundles. In the real world bundles contain many goods /commodities (they represent consumption sets) but in class we will limit bundles to a few goods. For example, • bundle A might be a used computer and a bottle of wine; • B, a used Rolex watch and a green shirt; • C, dinner at McDonalds with Justin Bieber and Miley Cyrus; • and D, dinner for two at Frasca, a fancy restaurant here in Boulder, wine included, with a guest, plus a chess board. Another item could be none of the above, na, which implies the status quo. So, picture four bundles, plus the status quo, so five bundles. You can have one and only one of these five bundles, but you must choose one of these alternatives. Write down your first and second choice Which alternative/bundle would you rank last?What is the opportunity cost of your choice? The opportunity cost of your choice is what you ranked second By taking your first choice, you gave up your second choice—you gave up the “opportunity” of having it, so the item you ranked second is the opportunity cost to you of having the bundle you ranked first. For example, my first choice would have been McDonalds with the kids, my second, the used Rolex and green shirt—I think I look good in green. So, for me, the opportunity cost of acquiring the Big Mac “Special,” is the watch and shirt – I gave up the watch and shirt to get the Big Mac Special. Note that when I made my choice I also gave up my third, fourth, and fifth choice, but all of these are ranked lower than #2, so don’t fully reflect what I sacrificed to get #1 Note that there is an opportunity cost even if all of the items have a zero monetary cost.If you ranked the bundles, D, A, na, C, B The opportunity cost of acquiring D, is bundle A (your second choice) Note that even though you prefer A over the status-quo, you are “worse off” with A than with D because you choose D over A. The concept of opportunity remains the same no matter what the alternatives in the choice set represent, no matter the number of alternatives in the choice set, and no matter how you feel about the alternatives relative to the current state. The choice set, is simply the set of things from which you must choose. It represents your constraint. In the first lecture, the partner set and budget set were both examples of choice sets.If your ranking was na, C, B, A, D? You prefer none of them to one of them. So, C, B, A, and D will all make you worse off, in increasing degrees of worseness. The opportunity cost of choosing none of the above is C, the least of the bads. For example, C, B, A and D might be increasingly bad dates. By staying home, choosing none of the above, you gave up going out with C. But if na (staying home dateless) was not available, you would go out with C. Explaining: going out with C is better than going out with B, and if staying home in not an option, you have to go out with someone. If your ranking was D, na, C, B, A? The opportunity cost of choosing D is “none of the above” What does that mean? Think it through in terms of dates: you prefer staying home alone to going out with C, B, or A. So by choosing D, you have given up the opportunity to stay home alone.When determining opportunity cost, need to consider all of the aspects and implications of what you would have chosen if your first choice had not been available. Assume you ranked the computer/wine first and the Rolex/shirt second, knowing that if you came home with the watch your girlfriend would immediately dump you because she hates “posers,” and wearing the Rolex would prove to her that you are a poser. (Economists assume you know the implications of what you do.) But you rank the Rolex over the Frasca dinner with a chess board. For you, the opportunity cost of taking the computer/wine is a world with the Rolex but no girlfriend. (Your second choice implies no girlfriend.) We have to be very careful here in how we say this. One of the things you gave up when you chose the computer/wine bundle is not having your current girlfriend. In addition, you prefer a world with a Rolex and no girlfriend, to taking her to dinner at Frasca.Is the opportunity cost of blatantly cheating on your rich wife simply yelling, screaming and less money? Consider the run-up to the election that first elected Barak President. Barak was running against the Republican, John McCain. John McCain was, and is, married to Cindy McCain. Now I am going to make up some stuff: Let’s assume that if “Wanda Sue” had never appeared on John’s campaign bus, John would have stayed happily married and not cheated with Wanda. That is, if Wanda had never appeared on the scene John’s first choice included remaining married and faithful with Cindy. But Wanda does appear, John’s torrid affair becomes public, as could be predicted, and Cindy publicly dumps John right before the election. What are some of the things included in John’s first choice? • the affair with Wanda • Lots of bad publicity • Reduced income (Cindy had all the money) • And, a zero probability of being President. (In the U.S. we would not elect someone who had an affair with someone named Wanda.)What is included in the opportunity cost to John choosing the affair with Wanda? • Marriage with Cindy • A good relationship with Cindy • Having a rich wife • Some probability of getting elected President. One might say that John having an affair with Wanda is very similar to what happened to John Edwards. John Edwards was a leading Democratic contender for President a few years back until. He got caught having an affair, and a kid, with the women on the left, all while his wife was suffering from cancer. What is included in the opportunity cost to John Edwards of pulling a “John Edwards”? It is the life he would be living if he had not pulled a “John Edward”. This includes stuff he would have bought that he