12/18/12 opportunity cost : The New Palgrave Dictionary of Economics

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opportunity  cost
James  M.  Buchanan
From  The  New  Palgrave  Dictionary  of  Economics,  Second  Edition,  2008
Edited  by  Steven  N.  Durlauf  and  Lawrence  E.  Blume
Alternate  versions  available:  1987  Edition

Keywords
choice;;  opportunity  cost;;  scarcity

Article

The  concept  of  opportunity  cost  (or  alternative  cost)  expresses  the  basic  relationship  between  scarcity  and
choice.  If  no  object  or  activity  that  is  valued  by  anyone  is  scarce,  all  demands  for  all  persons  and  in  all
periods  can  be  satisfied.  There  is  no  need  to  choose  among  separately  valued  options;;  there  is  no  need  for
social  coordination  processes  that  will  effectively  determine  which  demands  have  priority.  In  this  fantasized
setting  without  scarcity,  there  are  no  opportunities  or  alternatives  that  are  missed,  forgone,  or  sacrificed.
Once  scarcity  is  introduced,  all  demands  cannot  be  met.  Unless  there  are  ‘natural’  constraints  that
predetermine  the  allocation  of  end-­objects  possessing  value  (for  example,  sunshine  in  Scotland  in  February),
scarcity  introduces  the  necessity  of  choice,  either  directly  among  alternative  end-­objects  or  indirectly  among
institutions  or  procedural  arrangements  for  social  interaction  that  will,  in  turn,  generate  a  selection  of
ultimate  end-­objects.
Choice  implies  rejected  as  well  as  selected  alternatives.  Opportunity  cost  is  the  evaluation  placed  on  the
most  highly  valued  of  the  rejected  alternatives  or  opportunities.  It  is  that  value  that  is  given  up  or  sacrificed
in  order  to  secure  the  higher  value  that  selection  of  the  chosen  object  embodies.

Opportunity  cost  and  choice

Opportunity  cost  is  the  anticipated  value  of  ‘that  which  might  be’  if  choice  were  made  differently.  Note  that
it  is  not  the  value  of  ‘that  which  might  have  been’  without  the  qualifying  reference  to  choice.  In  the  absence
of  choice,  it  may  be  sometimes  meaningful  to  discuss  values  of  events  that  might  have  occurred  but  did  not.
It  is  not  meaningful  to  define  these  values  as  opportunity  costs,  since  the  alternative  scenario  does  not
represent  a  lost  or  sacrificed  opportunity.  Once  this  basic  relationship  between  choice  and  opportunity  cost
is  acknowledged,  several  implications  follow.
First,  if  choice  is  made  among  separately  valued  options,  someone  must  do  the  choosing.  That  is  to  say,
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a  chooser  is  required,  a  person  who  decides.  From  this  the  second  implication  emerges.  The  value  placed  on
the  option  that  is  not  chosen,  the  opportunity  cost,  must  be  that  value  that  exists  in  the  mind  of  the  individual
who  chooses.  It  can  find  no  other  location.  Hence,  cost  must  be  borne  exclusively  by  the  chooser;;  it  can  be
shifted  to  no  one  else.  A  third  necessary  consequence  is  that  opportunity  cost  must  be  subjective.  It  is  within
the  mind  of  the  chooser,  and  it  cannot  be  objectified  or  measured  by  anyone  external  to  the  chooser.  It
cannot  be  readily  translated  into  a  resource,  commodity,  or  money  dimension.  Fourth,  opportunity  cost
exists  only  at  the  moment  of  decision  when  choice  is  made.  It  vanishes  immediately  thereafter.  From  this  it
follows  that  cost  can  never  be  realized;;  that  which  is  rejected  can  never  be  enjoyed.
The  most  important  consequence  of  the  relationship  between  choice  and  opportunity  cost  is  the  ex  ante
or  forward-­looking  property  that  cost  must  carry  in  this  setting.  Opportunity  cost,  the  value  placed  on  the
rejected  option  by  the  chooser,  is  the  obstacle  to  choice;;  it  is  that  which  must  be  considered,  evaluated,  and
ultimately  rejected  before  the  preferred  option  is  chosen.  Opportunity  cost  in  any  particular  choice  is,  of
course,  influenced  by  prior  choices  that  have  been  made,  but,  with  respect  to  this  choice  itself,  opportunity
cost  is  choice-­influencing  rather  than  choice-­influenced.

Other  notions  of  cost

The  distinction  between  opportunity  cost  and  other  conceptions  or  notions  of  cost  is  best  explained  in  this
choice-­influencing  and  choice-­influenced  classification.  Once  a  choice  is  made,  consequences  follow,  and
these  consequences  may,  indeed,  involve  utility  losses,  either  to  the  person  who  has  made  initial  choice  or  to
others.  In  a  certain  sense  it  may  seem  useful  to  refer  to  these  losses,  whether  anticipated  or  realized,  as  costs,
but  it  must  be  recognized  that  these  choice-­determined  costs,  as  such,  cannot,  by  definition,  influence  choice
itself.
A  single  example  may  clarify  this  point.  A  person  chooses  to  purchase  an  automobile  through  an
instalment  loan  payment  plan,  extending  over  a  three-­year  period.  The  opportunity  cost  that  informs  and
influences  the  choice  is  the  value  that  the  purchaser  places  on  the  rejected  alternative,  in  that  case  the
anticipated  value  of  the  objects  which  might  be  purchased  with  the  payments  required  under  the  loan.
Having  considered  the  potential  value  of  this  alternative,  and  chosen  to  proceed  with  the  purchase,  the
consequences  of  meeting  the  loan  schedule  follow.  Monthly  payments  must  be  made,  and  it  is  common
language  usage  to  refer  to  these  payments  as  ‘costs’  of  the  automobile.  The  individual  will  clearly  suffer  a
sense  of  utility  loss  as  the  payments  come  due  and  must  be  paid.  As  choice-­influencing  elements,  however,
these  ‘costs’  are  irrelevant.  The  fact  that,  in  a  utility  dimension,  post-­choice  consequences  can  never  be
capitalized  is  a  source  of  major  confusion.
Economists  recognize  the  distinction  being  made  here  in  one  sense.  With  the  familiar  statement  that
‘sunk  costs  are  irrelevant’,  economists  acknowledge  that  the  consequences  of  choices  cannot  influence
choice  itself.  On  the  other  hand,  by  their  formalized  constructions  of  cost  schedules  and  cost  functions,
which  necessarily  imply  measurability  and  objectifiability  of  costs,  economists  divorce  cost  from  the  choice
process.

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Essentially  the  same  results  hold  for  accountants,  who  normally  measure  estimated  costs  strictly  in  the  ex
post  or  choice-­influenced  sense.  Those  ‘costs’  estimated  by  accountants  can  never  accurately  reflect  the
value  of  lost  or  sacrificed  opportunities.  Numerical  estimates  could  be  introduced  in  working  plans  for
alternative  courses  of  action  prior  to  decision,  but  such  estimates  of  opportunity  costs  would  be  the
accountant's  measure  of  the  values  for  projects  not  undertaken  rather  than  the  value  of  commitments  made
under  the  project  chosen.
As  suggested,  choice-­influencing  opportunity  costs  exist  only  for  the  person  who  makes  choice.  By
definition,  opportunity  costs  cannot  ‘spill  over’  to  others.  There  may,  of  course,  be  consequences  of  a
person's  choice  that  impose  utility  losses  on  other  persons,  and  it  is  sometime  useful  to  refer  to  these  losses
as  ‘external  costs’.  The  point  to  be  emphasized  is  that  these  external  costs  are  obstacles  to  choice,  and  hence
a  measure  of  forgone  opportunities,  only  if  the  individual  who  chooses  takes  them  into  account  and  places
his  own  anticipated  utility  evaluation  on  them.

Opportunity  cost  and  welfare  norms

The  source  of  greatest  confusion  in  the  analysis  and  application  of  opportunity  cost  theory  lies  in  the
attempted  extension  of  the  results  of  idealized  market  interaction  processes  to  the  definition  of  rules  or
norms  for  decision  makers  in  non-­market  settings.  In  full  market  equilibrium,  the  separate  choices  made  by
many  buyers  and  sellers  generate  results  that  may  be  formally  described  in  terms  of  relationships  between
prices  and  costs.  Under  certain  specified  conditions,  prices  are  brought  into  equality  with  marginal  costs
through  the  working  of  the  competitive  process.  Further,  the  general  equilibrium  states  described  by  these
equalities  are  shown  to  meet  certain  efficiency  norms.
Prices  may  be  observed;;  they  are  objectively  measurable.  A  condition  for  market  equilibrium  is
equalization  of  prices  over  all  relevant  exchanges  for  all  units  of  a  commodity  of  service.  From  this
equalization  it  may  seem  to  follow  that  marginal  costs,  which  must  be  brought  into  equality  with  price  as  a
condition  for  the  equilibrium  of  each  trader,  are  also  objectively  measurable.  From  this  the  inference  is
drawn  that,  if  marginal  costs  are  then  measured,  ‘efficiency’  in  resource  use  can  be  established
independently  of  the  competitive  process  itself  through  the  device  of  forcing  decision  makers  to  bring  prices
into  equality  with  marginal  costs.
The  whole  logic  is  a  tissue  of  confusion  based  on  a  misunderstanding  of  opportunity  cost.  The
equalization  of  marginal  opportunity  cost  with  price  for  each  trader  is  brought  about  by  the  adjustments
made  by  each  trader  along  the  relevant  quantity  dimension.  The  fact  that  the  marginal  opportunity  costs  for
all  traders  are  all  brought  into  equalization  with  the  relevant  uniform  price  implies  only  that  traders  retain  the
ability  to  adjust  quantities  of  goods  until  this  condition  is  met.  There  is  no  implication  to  the  effect  that
marginal  opportunity  costs  are  equalized  in  some  objectively  meaningful  sense  independently  of  the
quantity  adjustment  to  price.
Consider  an  idealized  market  for  a  good  that  is  observed  to  be  trading  at  a  uniform  price  of  $1  per  unit.
The  numeraire  value  of  the  anticipated  lost  opportunity  is  $1  for  each  trader.  But  it  is  only  as  quantity  is

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adjusted  that  the  trader  can  bring  the  numeraire  value  of  his  subjectively  experienced  and  anticipated  utility
sacrifice  into  equality  with  the  objectively  set  price  that  he  confronts.  The  anticipated  value  of  that  which  is
given  up  in  taking  a  course  of  action  is  no  more  objectifiable  and  measurable  than  the  anticipated  value  of
the  course  of  action  itself.  The  two  sides  of  choice  are  equivalent  in  all  respects.
Independently  of  market  choice,  there  is  no  means  through  which  marginal  opportunity  costs  can  be
brought  into  equality  with  prices.  Hence,  any  ‘rule’  that  directs  ‘managers’  in  non-­market  settings  to  use
cost  as  the  basis  for  setting  price  is  and  must  remain  without  content.  There  is,  however,  a  second  equally
important  criticism  of  the  welfare  rule  that  opportunity  cost  reasoning  identifies,  quite  apart  from  the
measurability  question.  Even  if  the  first  criticism  is  ignored,  and  it  is  assumed  that  marginal  opportunity  cost
can,  in  some  fashion,  be  measured,  instructions  to  ‘managers’  to  use  cost  to  set  price  must  rely  on
‘managers’  to  behave,  personally,  as  robots  rather  than  rational  utility-­maximizing  individuals.  Why  should
a  ‘manager’  be  expected  to  follow  the  rule?  Would  he  not  be  expected  to  behave  so  that  marginal  cost,  that
which  he  faces  personally,  be  brought  into  equality  with  the  anticipated  value  of  the  benefit  side  of  choice?
The  fact  that  the  ‘manager’  remains  in  a  non-­market  setting  insures  that  he  cannot  be  the  responsible  bearer
of  the  utility  gains  and  losses  that  his  choices  generate.  His  own,  privately  sensed,  gains  and  losses,
evaluated  either  prior  to  or  after  choice,  must  be  categorically  different  from  those  anticipated  for  principals
before  choice  and  enjoyed  and/or  suffered  by  principals  after  choice.

Opportunity  cost  and  the  choice  among  institutions

As  noted  earlier,  in  the  absence  of  ‘natural’  constraints  that  predetermine  allocation,  the  introduction  of
scarcity  introduces  the  necessity  of  choice,  either  directly  among  ultimate  ‘goods’  or  indirectly  among  rules,
institutions,  and  procedures  that  will  operate  so  as  to  make  final  allocative  determinations.  Opportunity  cost
in  the  second  of  these  choice-­settings  remains  to  be  examined.  In  a  sense,  the  use  of  institutionalized
procedures  to  generate  allocations  of  scarce  resources  may  eliminate  ‘choice’  in  the  familiar  meaning  used
above  and  is  akin  in  this  respect  to  the  ‘natural’  constraints  noted.  Results  may  emerge  from  the  operation  of
some  institutional  process  without  any  person  or  group  of  persons  ‘choosing’  among  end-­state  alternatives,
and,  hence,  without  any  subjectively-­experienced  opportunity  cost.  Despite  the  absence  of  this  important
bridge  between  cost  and  choice  in  the  ordinary  sense,  however,  values  may  be  placed  on  the  ‘might  have
beens’  that  would  have  emerged  under  differing  allocations.  The  patterns  of  these  estimated  value  losses,
over  a  sequence  of  institution-­determined  allocations,  may  enter,  importantly,  in  a  rational  choice  calculus
involving  the  higher-­level  choice  among  alternative  institutional  procedures  for  allocation.  In  this  higher-­
level  choice,  opportunity  cost  again  appears  as  the  negative  side  of  choice  even  if  ‘choice’  in  the  standard
usage  of  the  term  is  not  involved  in  the  making  of  allocations,  taken  singly.
Consider  the  following  extreme  example.  There  are  two  mutually  exclusive  thermostat  settings  for  a
building,  High  and  Low.  An  institution  is  in  being  that  uses  an  unbiased  coin  to  ‘choose’  between  these  two
settings  each  day.  It  is  meaningful  for  an  individual  to  discuss  the  potential  value  to  be  anticipated  if  the
setting  is  High  rather  than  Low,  even  if  the  individual  does  not  make  the  selection,  individually  or  as  a

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member  of  a  collective.  The  setting  that  is  ‘chosen’  by  the  coin  flip  has  consequences  for  individual  utility
and  these  consequences  may  be  anticipated  in  advance  of  the  actual  ‘choice’.  So  long  as  the  institutional
procedure  remains  in  effect,  however,  with  respect  to  a  single  day's  selection,  the  anticipated  value  lost  by
one  setting  of  the  thermostat  rather  than  the  other  cannot  represent  opportunity  cost.
Suppose,  now,  that  instead  of  the  unbiased  and  equally  weighted  device,  the  institution  in  being  is  one
that  allows  all  persons  in  the  building  to  vote,  each  morning,  on  the  thermostat  setting  with  the  majority
option  ‘chosen’  for  the  day.  Assume,  further,  that  the  group  of  voters  is  large,  so  that  the  influence  of  a
single  person  on  the  expected  majoritarian  outcome  is  quite  small.  It  is  important  to  emphasize  that,  in  this
procedure,  as  with  the  coin  toss,  no  person  really  ‘chooses’  among  the  alternative  end-­states.  Each  voter
confronts  the  quite  different,  intra-­institutional  choice  between  ‘voting  for  High’  and  ‘voting  for  Low’,  with
the  knowledge  that  any  individual  has  relatively  little  influence  on  the  outcome.  In  the  choice  that  he
confronts,  the  voter  cannot  rationally  take  into  account  the  anticipated  losses  from  the  ultimate  alternatives,
either  for  himself  or  for  others,  in  any  full-­value  sense  of  the  term.  The  loss  anticipated  from,  say,  a  Low
thermostat  setting  may  be  estimated  to  be  valued  at  $1,000  for  the  individual.  Yet  if  he  considers  himself  to
have  an  influence  on  the  outcome  of  the  voting  choice  only  in  one  case  out  of  a  thousand,  the  expected
utility  value  of  the  anticipated  loss  will  be  only  $1  in  terms  of  the  numeraire.  This  $1  will  then  represent  the
numeraire  value  of  the  opportunity  cost  involved  in  voting  for  High.
Since  these  same  results  hold,  with  possibly  differing  values,  for  all  voters,  no  one  ‘chooses’  in
accordance  with  fully  evaluated  gains  and  losses.  ‘Choices’  emerge  from  the  institutional  procedure  without
full  benefit  –  cost  considerations  being  made  by  anyone,  taken  singly  or  in  aggregation.  In  the  relevant
opportunity-­cost  sense,  effective  choice  is  shifted  to  that  among  alternative  institutions.  The  results  of  the
‘choices’  made  within  an  institution  over  a  whole  sequence  of  periods  (over  many  days  in  our  thermostat
example)  may,  of  course,  become  data  for  the  choice  comparison  among  institutions  themselves.  And,  to  the
extent  that  the  individual,  when  confronted  with  a  choice  among  institutions,  knows  that  he  is  individually
responsible  for  the  selection,  the  whole  opportunity  cost  logic  then  becomes  relevant  at  the  level  of
institutional  or  constitutional  choice.  This  result  is  accomplished,  however,  only  if  each  person  in  the
relevant  community  does,  in  fact,  become  the  chooser  among  institutional  rules.  Only  if,  at  some  ultimate
level  of  institutional-­constitutional  choice  the  Wicksellian  unanimity  rule  becomes  operative,  hence  giving
any  person  potential  choice  authority,  can  the  opportunity  cost  of  alternatives  for  choice  be  expected  to  enter
and  to  inform  individual  decisions.

Summary

Opportunity  cost  is  a  basic  concept  in  economic  theory.  In  its  rudimentary  definition  as  the  value  of
opportunities  forgone  as  a  result  of  choice  in  the  presence  of  scarcity,  the  concept  is  simple,  straightforward,
and  widely  understood.  In  the  analysis  of  choices  made  by  buyers  and  sellers  in  the  marketplace,  the
complexities  that  emerge  only  in  rigorous  definition  of  the  concept  remain  relatively  unimportant.  But  when
attempts  are  made  to  extend  opportunity  cost  logic  to  non-­market  settings,  either  in  the  derivation  of  norms

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to  guide  decisions  or  in  application  to  choice  within  and  among  institutions,  the  observed  ambiguity  and
confusion  suggest  that  even  so  basic  a  concept  requires  analytical  clarification.

Bibliography
Alchian,  A.  1968.  Cost.  Encyclopedia  of  the  Social  Sciences,  vol.  3.  New  York:  Macmillan.

Buchanan,  J.M.  1969.  Cost  and  Choice.  Chicago:  Markham,  Republished  as  Midway  Reprint,  Chicago:
University  of  Chicago  Press,  1977.

Buchanan,  J.M.  and  Thirlby,  G.F.,  eds.  1973.  LSE  Essays  on  Cost.  London:  Weidenfeld  and  Nicholson.
Reissued  by  New  York  University  Press,  1981.

Coase,  R.H.  1960.  The  problem  of  social  cost.  Journal  of  Law  and  Economics  3  (October),  1–44.

How  to  cite  this  article

Buchanan,  James  M.  "opportunity  cost."  The  New  Palgrave  Dictionary  of  Economics.  Second  Edition.
Eds.  Steven  N.  Durlauf  and  Lawrence  E.  Blume.  Palgrave  Macmillan,  2008.  The  New  Palgrave  Dictionary
of  Economics  Online.  Palgrave  Macmillan.  18  December  2012
<http://www.dictionaryofeconomics.com/article?id=pde2008_O000029>
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