Finance - Opportunity Cost

Whenever one decides to do something, alternative decisions can usually be made. Those decisions may be more or less valuable than the current decision being considered.

Opportunity Cost is a benefit that a person could have received but gave up to take another course of action.

Consider the following situation:

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?

The alternative to going to see Eric Clapton is going to see Bob Dylan. It has a $50 value to you, but you have to pay $40 in order to go. Thus, you would get a net of $10 of value if you were to go to Bob Dylan's concert. This $10 of value is the opportunity cost of going to see Eric Clapton, assuming there are no other alternatives with a higher value.

It is crucial to understand that opportunity cost is primarily a mental trick one could employ to make better decisions, not something real:

• The space of possible choices may not necessarily even have "the next best choice". For example, imagine that your optimization objective is some quadratic form in `\mathbb{R}^n`.
• When optimizing an objective function, it is already necessary to consider all possible choices. Whether one considers the best and the next best choice once the best choice is discovered is inconsequential to the optimization process itself.
• Since the opportunity cost is the result of optimization itself, opportunity cost itself can not directly factor into the optimization process.

In fact, opportunity cost is not well-understood even by the most trained economists ^{opportunity-cost-not-simple-or-fundamental}. Given the above question, most economists answer the question incorrectly - as well as monkeys randomly pressing buttons would have.

Extra attributes on quote: XmlAttr(name=from, value=String(value=opportunity-cost-not-simple-or-fundamental))

That means that 3 to 7 years devoted to studying economics has no overall influence whatsoever on the ability to answer correctly a question about an idea that many claim to be one of the most fundamental concepts in the subject.

Thus, we shall not use opportunity cost as a concept. Instead, we shall attempt to always consider the space of all available choices.