Lecture # 8 Opportunity Cost Economics 103 Lecture # 8 Opportunity Cost

What is Cost? The most common notion of cost is … historical cost. - this is one of the most useful ideas in economics but it is one of the least understood. The most common notion of cost is … historical cost. In economics we don’t use this notion of cost.

We don’t use it because often it is irrelevant for behavior. In each case, the historical price is completely irrelevant for how you behave now.

In Economics cost is often called Opportunity Cost to highlight the difference with historical cost. Costs depend on the alternatives you face.

“My wife and I decided we could either have a vacation or a divorce. We chose a divorce because a vacation only lasts a week, but a divorce can last a lifetime.”

Why would a loaf of bread cost $1.35? What does that mean in terms of opportunity cost? How much does it cost to make, eat, sell a hamburger

To figure out the cost of the next best alternative, you may need to add some costs up. But you have to wait in line for 10 minutes. Should this be part of the cost?

If student’s don’t like tuition increases …

Don’t confuse Costs with Bads. A swimming pool has lot of good things about it … but it also has some bad things.

The cost of the pool is the value of the next best alternative. For example a really nice band saw.

A nice understanding of Opportunity Cost: Friedman vs. ??

The Broken Window Fallacy

Cost Questions: You find a diamond in your back yard worth $4000. You decide to put it in a ring for $1000 and keep it. Did keeping the ring cost you $1000? 2. You buy a ticket for Supertramp for $150. At the gate a scalper offers you $300 to buy the ticket. You turn it down. Did it cost $150 to see the band? 3. You own a art shop and you’ve bought a painting for $3000 and plan to sell it for $6000. Before you sell you find out the artist has just died, and his work is now selling wholesale for $5000. People are phoning you asking about the painting. Will you act as if the painting cost you $5000? 4. Why would a volunteer army cost less to a society than a draft army?

More Cost Questions. 1. If it rains, is it more costly to use self-serve pumps? 2. If I hate doing the weeding, but my wife loves it, is it more costly for me to do it? 3. Does it cost more for a surgeon to operate on a poor person? 4. Are costs for a store higher if it owns or rents its space? 5. If Costco comes along and offers to rent the store space, did the store’s costs increase? -if costs increase, is this a bad thing? - costs are not the same as bads.

Still More Cost Questions 1. If you inherit something, does it cost to use it? 2. What’s wrong with this conversation: “Boy, there’s never anyone in this club” “It doesn’t matter, the owners own the building and don’t have to pay rent. 3. What’s wrong with this conversation: “I wonder what he needs to charge to make a profit.” “That depends on how much of a downpayment he made.” 4. Who sleeps more: high or low wage people? -teenagers, Nygard case, Lottery winners.

One Last Cost Question: Movie breaks at Schindler’s List …. I get a coupon Flight is delayed from Montreal … I get another flight. I take back a toaster that doesn’t work … I get my money back. What is going on?

Some actions involve expenditures that have no salvageable option. Non-salvageable costs are called sunk costs

More Sunk costs examples: Movie about terrorism. Scheduled release: October 2001. Cost $70 million, but was not released.

Aside from the distinction between Sunk and Ordinary Costs, costs might be either variable or fixed. Costs can be any combination of fixed/variable vs Sunk and Ordinary.

Suppose you own a Comic Book Store. What examples of costs would fit into the matrix below? Heat in the reading room Custom made sign outside. “special” pin given away with every purchase. Comic books bought from the wholesaler

We are going to assume that all fixed costs are sunk, and all variable costs are ordinary costs.

Airlines don’t charge you for pop like they do for booze. Can that explain why it is so hard to get:

The distinction between Sunk and ordinary costs is important because behavior depends on ordinary costs, not sunk costs. Suppose you are a TV retailer and you buy 28 sets for $19600, and as a result you win a free two week trip to Las Vegas. After you get back you find out you can’t sell one TV. The TV’s would sell for $5600 as junk, and an orphanage has offered $20,000 for the works. You wonder what your costs are: Wholesale costs …. $19600. Since its bad business to sell below costs, you turn the orphanage down. Did you make the right decision? Interest for 1month … $196 Handling … $2000 Advertising …. $800 Display Space … $1400 Total: $23,996