For your birthday, your friends have joined forces and offer you a choice among the following options (they will pay all expenses of your choice) (3 Marks): A) A two-week trip to an exotic...
- For your birthday, your friends have joined forces and offer you a choice among the following options (they will pay all expenses of your choice) (3 Marks):
A) A two-week trip to an exotic destination;
B) A new, high-tech mountain bike,
C) An annual pass to your preferred sports team games,
D) A dinner with your preferred movie star.
Suppose your subjective valuations of these options are as follows: A)$800, B)$700, C)$1500, and D)$1000. If you are a rational individual, you will obviously choose C, the annual pass, because it is the option of your highest valuation.
a)What is your opportunity cost of choosing option C? Explain.
b)Now, suppose your friends announce at the last minute a fifth option, E, a cheque of $1100. What is now your opportunity cost of choosing option C?
c)As you can see, the theory of opportunity cost implies that the cost of an action depends on other, seemingly unrelated facts. Why does this make sense?
The opportunity cost is the cost you pay of what you can't do instead. Its value is determined by your second-best alternative.
(a) Since we are handed an objective cardinal utility function and a limited number of alternatives, for the purposes of this problem it's easy to figure out what our opportunity cost is: The best option is worth $1500 to us, and the second-best option is worth $1000 to us, so the opportunity cost is the $1000 of our second-best alternative. Our real economic profit is the difference, $500.
(b) If we are offered a new alternative that's worth $1100 to us, that now becomes our second-best alternative; so our opportunity cost rises from $1000 to $1100. Our real economic profit is now only $400.
(c) It may seem a bit counter-intuitive that the cost we pay and therefore profit we get from doing something depends on something else we didn't do, but the key is to understand that we could have. In fact, most of what we call costs in the real world are ultimately opportunity costs, because a dollar bill has no inherent value; it's only valuable to us because it can be used to buy things. So when you spend $100 on something, you're not actually losing anything by not having the $100; you're losing the opportunity to spend that $100 on something else.
You might even actually feel worse about your decision if you have a higher opportunity cost, thus making that cost directly reflected in your experienced utility. In the question we just answered, we've gone from "paying" dinner with the movie star to "paying" $1100. So we don't feel as thrilled to get the season tickets, because they were $500 better than the dinner date, but only $400 better than the cash.
Opportunity costs can be defined as the benefits one gives up by selecting one alternative out of a list of choices. Thus, the individual gets to enjoy benefits of the option selected and forfeits the other options not taken.
Although a decision maker may be presented with a variety of choices, it is important to note that the opportunity cost is effectively made on a one-on-one basis against the selected choice. Thus, in determining the opportunity cost one does not combine all the options left out and measure them against the selected choice or select only one of the choices not taken to be measured against the option selected because all the options provided are mutually exclusive in nature.
In the scenario presented, the individual goes with option C. Thus, they pass up on the opportunity presented by A, B, and D. The opportunity cost, in this case, is determined by getting the difference between the selected option C and all the forfeited options separately.
$1500-1000(D) = 500
$1500-700(B) = 800
$1500-800(A) = 700
The same will be extended to the new option E as follows,
Option E presents the second best option because the opportunity cost is the least ($400) of all the options presented and option C remains the best overall.