You Think You Understand Your Opportunity Costs?

“….researchers found that exposure to introductory economics instruction was strikingly counterproductive”—Cornell University professor Robert H. Frank, New York Times, September 1, 2005

Do you think you know what opportunity cost is or why anyone should care what it is? “Sure,” you say. You’ve read Economics for Dummies. Or you picked up some version of the concept in a finance seminar, in economics 101, or simply Googled it. More likely, you’re clearly very smart and think you intuitively understand the idea. It’s not rocket science, you say. Presumably, even those who can’t define “opportunity cost” understand it–like the executives at the Decca, Pey, Philips, Columbia and HMV labels in 1963 after they all rejected the Beatles in 1962.

The Stumped Experts

A 2005 study by Paul J. Ferraro and Laura O. Taylor of Georgia State University, reported by the New York Times, September 9, 2005, suggested that the vast majority of professional economists and students of economics don’t really understand this key economic concept that underlies all decision making, including recruitment and job application decisions.

As a job applicant or a recruiter, do you think you understand the opportunity costs of your decisions any better than the experts and students did? Here is your chance to find out. At the 2005 annual meetings of the American Economic Association, researchers asked almost 200 professional economists to answer this question:

“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.” [Source: http://www.nytimes.com/2005/09/01/business/01scene.html?_r=3]

In the New York Times article,  “opportunity cost” was characterized as including “not only the explicit cost of the ticket, but also the implicit value of other opportunities that must be forgone to attend the concert”. Cornell economics professor Robert H. Frank, who offered that characterization as author of the New York Times article was also co-author, with Ben Bernanke, of Principles of Micro Economics.

The real shocker is that he said the survey reported that only 21.6% of the experts were able to answer the question correctly—a smaller percentage than the 25% that would have resulted if they had chosen an answer randomly! The correct answer: $10 (assuming the researchers themselves actually understood the concept).

The statistics were even more dismal for students presented the same question: “When they posed their original question to a large group of college students, the researchers found that exposure to introductory economics instruction was strikingly counterproductive. Among those who had taken a course in economics, only 7.4 percent answered correctly, compared with 17.2 percent of those who had never taken one.” [Ibid.] Notice how the performance of those with no background in economics compared with the 21.6% of the professional economists: quite favorably, from the viewpoint of the former, at least.

Something Wrong with the Survey?

To couch this challenge in recruitment terms, I have recast the question as this: “One of your interns is volunteering to do for free a one-hour job that must be done today.  An outside contractor is under consideration and is asking $40 per hour to do the one-hour job. In fact, you would be willing to pay the contractor up to $50 for that hour. Assume there are no other dollar-denominated or other categories of costs of taking on either candidate. Based on this information, what is the opportunity cost of using the intern? (a) $0, (b) $10, (c) $40, or (d) $50.”  Again, analogously and according to the researchers’ logic, the correct answer is supposed to be $10.

What was the reasoning behind the original conclusion?  Professor Frank: “The opportunity cost of seeing Clapton is the total value of everything you must sacrifice to attend his concert – namely, the value to you of attending the Dylan concert. That value is $10 – the difference between the $50 that seeing his concert would be worth to you and the $40 you would have to pay for a ticket. So the unambiguously correct answer to the question is $10.”

But, wait a minute: The total value of anything is not the same as the total cost. After all, there are bargains in life, which offer value that exceeds cost. Aren’t we talking about “opportunity cost”, rather than “opportunity value”? Moreover, costs should never equal value, since no one should exchange money or anything else for something of only equal or less value to themselves, unless it’s largesse or a donation. Otherwise, charity, misinformation, incomplete information and stupidity aside, if costs merely equal benefits, why do the deal?

And there is this: Taken literally, “the total value of everything you must sacrifice” is infinite, since there are an infinite number of things and opportunities to be forgone in choosing anything! (More on this below.)

The Opportunity Cost of Decisions vs. The Opportunity Cost of Allocated Resources and Dollars

It does, however, need to be noted that the original reasoning did imply a valid distinction that must be maintained: the distinction between the opportunity cost spent dollars represent and the opportunity cost a decision involving those spent dollars incurs. In the concert ticket case, although the spent dollars were zero, the decision to spend those zero dollars on the free concept incurred an associated dollar cost of $10—even though the explicit, upfront dollar cost of the Clapton ticket was $0. Don’t forget: An example like this one demonstrates that the opportunity cost of a decision doesn’t always equal the opportunity cost that corresponds to the numerical dollar value of the cash outlay. In this concert ticket scenario, the “decision opportunity cost” was greater than the “resource/cash outlay opportunity cost”.

Secondly, to prevent any misunderstanding, even if it were “total value”, it wouldn’t be total value “of everything you must sacrifice” as Professor Frank may have inadvertently and certainly ambiguously suggested, since this would include the value of the dinner you didn’t have, and—not or?–of the book you didn’t read, the walk you didn’t take, the time you might have spent with your sophomore economics-major daughter trying to figure out what “opportunity cost” really means, etc., ad infinitum.

The opportunity cost of a spent $10 bill is one—not all—of the other things you could have bought with that $10. [Remember: the opportunity cost of a spent $10 bill is not the same thing as the opportunity cost of the decision to spend the $10 bill.] Instead of the book you bought with that $10 or the employee you paid for an hour’s work, you could have bought a $10 dinner or a $10 DVD or….but not all of them with the same specific $10 expenditure.

So the opportunity cost of anything is measured either by what your decision or by what your resource (money, time, energy, etc) could have gotten you in terms of any one of the specific alternatives that were not selected—not by the aggregate of all of them. If it were the latter, the opportunity cost of anything would, given the infinite possibilities, be infinite, which it is not. Again, the decision to use the free Clapton ticket had a $10 opportunity cost; however, the free, $0 ticket had no associated dollar-denominated opportunity cost, because a $0 expenditure is worth nothing. Therefore, it costs nothing.

Explicit vs. Implicit Opportunity Costs—a Confusing Distinction?

We must be very careful in defining “opportunity cost”  in the way Professor Frank did—as comprising not only “the explicit cost of the ticket, but also the implicit value of other opportunities that must be forgone to attend the concert”. –which he also characterized as “the true economic cost of attending a concert”. Why the need for circumspection?

First, because this characterization totally and confusingly obliterates the important difference and valid distinction between “the cost of an opportunity” and “the opportunity cost”.  If I go to the movies and pay $10 for a ticket, when I could have gone to dinner with the same money, what is my opportunity cost in this instance, measured purely in dollar-denominated terms, as it was in the original survey question? On Professor Frank’s analysis it has to be the explicit cost of $10 for the ticket PLUS “the implicit value of other opportunities forgone”. Well, the implicit value of the forgone dinner is $10, since that was the price of the dinner forgone. Hence, Professor Frank’s analysis suggests that the opportunity cost of going to a $10 movie is actually $20, i.e., $10 for the movie ticket + $10 value of the forgone dinner. This is the “cost of the opportunity”, not what is normally intended by “the opportunity cost”.

Within the sphere of job searches and recruitment, this “explicit-implicit” model of “cost of an opportunity” confusingly conflates “cost of an opportunity” and “opportunity cost”, while it combines the two kinds of opportunity costs I’ve identified: the decision cost and the dollar or other resource-denominated cost. I say “confusingly”, because this “explicit + implicit cost” approach, despite whatever validity it may have in some applications, would lead to calculating the opportunity cost of hiring someone as the sum of the salary to be paid—the explicit cost—plus the implicit decision cost, estimated in whatever opportunities were lost by deciding in favor of the chosen candidate.

If you were to use this “explicit + implicit” approach, you would have risked succumbing to the same confusion as a boss who thinks that since hiring Jones is “a good opportunity”, his opportunity costs are Jones’ hourly wages plus the “value” of the “next-best candidate”/”next best-candidate that hourly wage could have purchased.  Only the alternatives that had to be given up should be considered as incurred opportunity costs of the decision—which, as was shown, trump the dollar-denominated cash costs—and only individually, one at a time, not collectively. The wages have, but are not, an opportunity cost. They are part of “the cost of an opportunity”, which has been confused with “opportunity cost”.

That kind of confusing calculation and the $20 figure in the preceding illustrative example would indeed be correct—but only if we are talking about “the cost of an opportunity”, i.e., “the true economic cost”, not what is more commonly and ambiguously considered to be “opportunity cost”. As the movie ticket example illustrates, this “explicit-implicit” model of opportunity cost can lead to results at direct variance with common expectations of what the opportunity cost of a $10 movie ticket should be.

What made $10 the correct answer to the survey question was that since the “resource opportunity cost” was $0 in that specific example, adding it to the “decision opportunity cost” reduced the “cost of the opportunity” to the (decision) opportunity cost. Had the ticket cost more than $0, the sum of the two costs—resource opportunity cost + decision opportunity cost—would have been transformed into “cost of the opportunity”.

The lesson here is that for non-zero costs, “opportunity cost” can be conceived as “resource opportunity cost” or “decision opportunity cost”—not their sum. Their sum will yield “cost of an opportunity”, which, as needs to be repeated, is not the same as “opportunity cost”.

Here are some non-equivalent, divergent, yet apparently widely accepted or intuited interpretations of that “opportunity cost”:

1.       The dollar-denominated “opportunity cost” of a $10 movie ticket vis-à-vis a $10 dinner is $0. Why? Because the “net opportunity cost”, i.e., the difference in dollar-denominated value is $0. This is an application of what I have identified as “resource opportunity cost”: what an expended resource could have purchased or obtained, but did not. Since what was forgone exactly equaled what was obtained, the net difference, which is a good measure of the attractiveness of one or the other, was $0. Call this concept the “net resource opportunity cost” or “resource comparison opportunity cost”, or “comparative resource opportunity cost”.

Also note that this dollar-denominated net opportunity cost will not always be zero, as the original survey puzzle solution, above, showed, inasmuch as accepting the $0 free Clapton ticket carried a $10 “decision opportunity cost” with respect to the Dylan concert. It is to be expected that if the decision opportunity cost of an expended resource is used to determine the net opportunity cost, the result will often be a non-zero opportunity cost.

2.       The dollar-denominated “opportunity cost” of a $10 movie ticket vis-à-vis a $10 dinner is $10.Why? Because the dinner that was forgone could have been substituted for the movie, at the same price. Call this “resource substitution opportunity cost”.

3.       The dollar-denominated “opportunity cost” $10 movie ticket vis-à-vis a $10 dinner cannot always be calculated objectively. Why? Because if the opportunity cost is calculated on the basis of the “decision opportunity cost”, and not the “resource opportunity cost”, the decision to spend $10—not the spent $10 as an expended resource!—will have incalculable consequences, not only because decisions rather than dollars should be compared, but also because attaching a reliable dollar value to alternative, forgone non-dollar denominated decisions may not be possible.

I repeat: in this instance and model it is the opportunity cost of a decision, not of a resource, that is being estimated. Unlike the resource-based case in which we clearly know of at least one dollar-denominated alternative to the $10 movie, viz., a $10 dinner, we may have to choose between deciding to go the $10 movie or to visit our sick grandmother in the hospital. We may also have to choose between completely non-dollar-denominated decisions and their consequences, such as choosing between listening to Mozart and listening to Lady Gaga.

Because the opportunity costs of two mutually exclusive decisions cannot be compared if only one or  if neither is dollar-denominated—which is probably the rule, rather than the exception, in many instances the difficulty of monetizing the alternative of the main decision or both decisions will preclude any accurate and precise estimate of the opportunity cost of the decision actually made.

Moreover, if this decision-based model is adopted, then the discussion of whether it should be “net” or “comparative” opportunity cost would have to be renewed in this decision-based, rather than resource-based, framework, which would then be called either “net/comparative decision opportunity cost” or “decision substitution opportunity cost”.

I leave that as an exercise for anyone whose brain is not yet fried by all of this.

Finally, in regard to Professor Frank’s conceptualizations, if you pay an employee $10/hour, you may, given Professor Frank’s characterizations of opportunity cost, be tempted to think that the money paid out is a “sacrifice” made in exchange for the value of labor, in the sense of having given it up as a benefit to another.

True, you gave money to the employee for his or her benefit, but the benefits are normally not one-sided, because the $10 is your half of an exchange, not a donation. So, you cannot imagine, as the survey question may be taken to suggest, that your opportunity costs include both your upfront cash costs and the foregone opportunities. For if the explicit cost of a ticket or an employment payment is included in the calculation of opportunity costs, as it was in the survey question, all opportunity costs will be exaggerated and transformed into “costs of an opportunity”.

The Doubled Opportunity Costs of Donating

In the case of donation, mentioned above, e.g., a donated $10 bill, it seems the money can legitimately count twice in the calculation, to yield an opportunity cost of $20. That’s only because in addition to what the $10 as a resource could alternatively have been used to get as a donation, e.g., malaria pills for kids in Africa, instead of cash for the Salvation Army, there is the opportunity cost associated with the decision to donate the cash instead of spending it on something of benefit to oneself.

The job application analogy to donation of cash would be this: Instead of charging an employer $10 for one hour, you work for free as an intern for that hour. Your explicit cost is your expended resource, in this case, time—1 hour. If you had been paid for that hour, your opportunity cost would have been only any one of the other countless ways in which you could have “spent” that hour, but did not, e.g., an hour spent re-writing your resume. However, since you decided to donate that hour, there is a second opportunity cost—the cost associated with the decision to not require payment for that hour.

For, in virtue of having given up that hour for free (but only in the exclusively dollar-denominated terms of the 2005 survey, excluding other benefits you may, e.g., as an unpaid intern, have rightly or wrongly expected from working for no pay, such as a letter of recommendation), you have incurred the opportunity cost associated with choosing no pay instead of payment.  Hence, your opportunity cost in this case is indeed double your explicit cost—2 hours, not 1 hour. Alternatively, assuming your labor is to you or your last boss worth $10/hour, your opportunity costs come to $20, rather than the $10 worth of alternatives that would have been available to you, but passed up, if you had decided to require payment and had been paid. Here, there is a doubling effect–and a legitimate one, unlike the doubling effect in Professor Frank’s apparent rendering of “opportunity cost” as “cost of opportunity”.

Given the blurred distinctions teased from the survey and from Professor Frank’s comments about and interpretation of the survey, perhaps it is not so surprising that even the experts were stumped.  As for you and for now, as a prelude to a second, upcoming article about opportunity costs, try to answer this second opportunity cost-related brain-teaser: Is it imaginable that you or I could have done anything as valuable as spending time on this article?