Opp. Cost of taking an action: what you forgo (give up) by not taking the next best alternative
Q:You decide to attend a concert, which costs $200. You value the concert at $400. Your next best
alternative is to go to a restaurant, which you value at $150 and which costs $100. What is the
A: $200 + ($150-$100) = $250
How does the opp. cost change if the satisfaction you get from going to the concert increases from
$400 to $500?
A: Not at all, since opp. cost does not depend on the value to you of the action taken.
Benefit of attending university for one year
Individual A: $275,000
If opp. cost increases from $15,000 (sept 2012) to $45,000 (sept. 2013), individual C will choose
NOT to attend university
1. Opp cost is the SAME for A, B ,and C
2. Because of individuals like C, enrolment declined in Sept. 2013
Action Taken Next Best Alternative
Direct Costs PLUS Dollar amount or value assigned by you
LESS Direct Costs
(each dollar spent has opp. cost
of one dollar)
Rational Decision Making
Undertake activity if marginal (additional) benefit exceeds marginal (additional) cost
1. Include all opportunity costs
2. Ignore sunk costs
Sunk Costs ("Fixed" Costs)
Costs which are incurred whether or not action is taken
Only relevant costs are those which can be avoided if action is not taken Examples:
Marginal benefit of attending sports event:
$100 (both Jack and Jill)
Ticket Price: $50
1. Jack buys one week in advance
2. Jill plans to buy on day of event
Subway breaks down on day of event, and Jack and Jill face unexpected cost: $75 for taxis
Should Jack attend event? Should Jill attend event?
Jack should attend:
MB= 100 MC=75 therefore, MB>MC
(ticket price is a sunk cost)
Jill should not attend:
MB= 100 MC=75+50=125 therefore, MB < MC
You buy a truck from a junkyard for $3,000. You plan to spend $2,000 to get it running, so you can
resell it for $6,000. If the truck does not run, its market value is nil.
Unfortunately, you discover that it will cost $5,000 to repair the truck.
Q: Do you repair the truck?
A: Marginal benefit: $6,000
Marginal cost : $5,000
MB>MC, so repair the truck (the 3,000 is the sunk cost as it is already spent)
Profit: $6,000 - $8,000 = ($2,000)
If do not repair truck, profit = $0 - $3,