Scarcity, choice and opportunity cost

Someone hands you a ticket to a concert tonight. You did not pay for it and you cannot sell it. You would happily have paid 50 for the ticket, so this feels like a gift of 50.

The same night, a different event is on. A ticket costs 40, and you would have paid up to 100 for it.

Go to the free concert and you have spent nothing. You have also given up something worth 60 — the 100 you would have got from the other event, minus the 40 it would have cost you. The free ticket cost you 60, and no money changed hands in either direction.

Predict

You quit a job paying 45,000 to run a small business full time. In its first year the business takes 60,000 in revenue and spends 20,000 on materials and rent. Did the year make you better off?

Choose one answer

Yes — the business made 40,000No — the year cost 5,000 against the alternativeIt is impossible to say without knowing the hoursYes, because the business is an asset and the job was not

Lock in answer

Where the cost hides

Opportunity cost is unpleasant to work with because it is counterfactual. The alternative did not happen, so there is no receipt, no statement and nobody to argue with. Every other cost in a life arrives with paperwork.

That asymmetry has a consistent direction. Costs with paperwork get managed carefully; costs without paperwork get ignored. Which is why people will spend an hour finding a cheaper insurance policy and will not spend ten minutes asking what the hour was worth.

Not the same thing

Explicit cost

Money that leaves your possession and arrives in someone else's.

Measured in

Units of currency, on a receipt

For example

The 40 you hand over for the second ticket.

Chase it alone and

Minimise it alone and you optimise the visible part of a decision while the invisible part does whatever it likes.

Opportunity cost

The value of the best alternative you gave up in order to do this instead.

Measured in

Whatever the alternative was worth, in the same units as the thing chosen

For example

The 60 of net value forgone by attending the free concert rather than the paid one.

Chase it alone and

Count it too enthusiastically and every choice looks like a loss, because there is always some alternative you can imagine going better.

Which is which? Put each one on a side.

• The interest a deposit would have earned had it stayed in the account

  Explicit costOpportunity cost

• The fee charged for moving money between two accounts

  Explicit costOpportunity cost

• Three years spent on a qualification rather than working

  Explicit costOpportunity cost

The mirror image

If opportunity cost is the cost people forget to count, sunk cost is the cost people cannot stop counting.

Money already spent is gone under every option in front of you. It is identical across all of them, which means it cannot distinguish between them, which means it is not part of the decision. The only question a decision can answer is what happens from here.

Why prices exist at all

Here is where this goes next, and it is worth flagging.

If everything is scarce, then everything competes for the same limited stock of hours, materials and attention, and something has to arbitrate. In a world of one person that arbitration is a personal judgement. In a world of billions of strangers it cannot be, because no one person knows what anything is worth to anyone else.

Prices are the arbitration mechanism that scales. That is the next lesson.

Check

A city owns a plot of land in its centre and is deciding what to build. Someone argues that a park costs nothing because the city already owns the land. What is the error?

Choose one answer

Owning the land does not make its best alternative use freeParks have maintenance costsThere is no error — the land is already paid forThe city should sell the land and keep the money

Check answer

›When the alternative is not obviousOptional

Opportunity cost is easy to state and often hard to compute, because it needs the value of the best forgone alternative and you rarely have a clean price for it.

Two things help. The first is to compare against a specific named alternative rather than an abstraction — not "something better", which is always available in the imagination, but the actual second-best thing you would really have done. The second is to notice when the alternative has an observable market price, as a wage or a rent does. Where it does, the comparison stops being a matter of taste.

Where it genuinely does not, the honest answer is that the cost is uncertain, not that it is zero.

Worth remembering

• Scarcity means everything has more than one possible use, so every choice gives something up.
• Opportunity cost is the value of the best alternative forgone, and it appears on no statement anywhere.
• A business can be accounting-profitable and still lose against the wage its owner stopped earning.
• Costs with paperwork get managed and costs without paperwork get ignored, which is a bias with a consistent direction.
• Money already spent is common to every option ahead and therefore cannot distinguish between them.