Tuesday, November 20, 2007

Economist's Notebook: Opportunity Cost

Apropos of my post below on corporate taxes, a reader asks me to explain opportunity cost. The concept of opportunity cost is one of the most important basic concepts an economics student must master. Opportunity costs are what you give up when you undertake a specific activity. Suppose you decide to go to a concert on a Friday night. The explicit costs of doing so are the price of the ticket, what you pay for parking, etc. The opportunity cost of doing so is the value to you of the next best activity forgone. When you are making the decision to go to the concert you probably take opportunity costs into account naturally. You may say to yourself, "well, I really like to go bowling on Friday nights, but this is a one-time chance and I really like the artist...so it is worth it even when figuring in the expense of the ticket" Giving up bowling is the opportunity cost of the concert. Though we often naturally figure in opportunity cost when we make such decisions, we don't generally understand that we are doing so, and that by doing so we are making sure we make the right decision.

So when a business thinks about making an investment in, say, a new plant, they must think about the opportunity cost of this investment. What is the next best thing they could do with the money? Suppose it is to invest it in bonds. So the decision to invest in a new plant must yield a higher return than this investment in bonds. The decision to locate a new plant in Oregon therefore means that a firm is giving up the opportunity to locate in another state and thus giving up the opportunity to take advantage of the educated workers, health care system and infrastructure of another state.

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