Wednesday, February 09, 2005

Opportunity Cost - The Cost of our Choices

Opportunity Cost is defined as the value of the next best alternative when we make a choice. In other words, when you decide to wash the car rather than clean the garage the opportunity cost of your clean car then becomes not being able to clean the garage. When you made the decision, a clean car was more valuable to you than a clean garage.

Opportunity cost can be stated in terms of money but usually involves more than just money. When you spend $12 on a movie ticket that is $12 that you no longer have to spend on drinks with friends afterward. But, even if you have the money, you may not be able to do both things. Your co-workers invite you to join them for drinks after work on Friday but you spouse wants you to join her and her visiting parents for dinner at a restaurant after work. You may have enough money to do both things but, since they both occur at the same time you have to choose one or the other and the opportunity cost of your choice is the function you did not attend. Time is also a scarce resource and, like money, it is often limitations on time that force us to make choices.

The choices may be between two things we like - two of your favorite recording artists are giving a single performance at different clubs at the same time and you have to choose one or the other. They may also be things we do not like but must choose one - a cancer patient having to choose between death from cancer in the next couple of years or chemotherapy treatments now that will make them sick for months and cause them to temporarily lose their hair. Neither option is attractive but a choice must be made. In both of the examples above the option not chosen is the opportunity cost.

Whenever people want more than one thing but lack resources to get everything they want at that time they are forced to prioritize and choose what they feel will give them the most satisfaction per unit of resources spent. Society and the government often utilize the concept of opportunity cost to encourage or discourage certain options that people may choose. They do this by placing taxes or fines on options they want to discourage thereby increasing the opportunity cost of that option. High taxes on cigarettes or fines for speeding are intended to increase the opportunity cost of choosing these options.

Tax deductions, government grants and subsidies are used to lower the opportunity cost of certain options thereby encouraging people to choose them. A young person is forced to choose between a sleek new car or going to college. For the car the person will have to borrow the money at higher interest market rates and faces the prospect of an asset that will lose value and be worthless in a few years - but the person gets the immediate satisfaction of good transportation and prestige of owning an expensive new car. The education promises a longer term return but requires work in the interim and the money also has to be borrowed for this. Tuition subsidies for courses taken at public colleges, Pell and other grants to pay some of the costs and subsidized interest rates on student loans all serve to reduce the cost of a college education and make it a more attractive choice to the young person.

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