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Suppose you have 2 activities, A and B. Doing activity A gives a return of 100 dollars, doing activity B gives a return of -50 dollars. What would be the opportunity cost of choosing activity B? 100 dollars or 150 dollars.

Oxford American Dictionary gives a pretty standard definition of opportunity cost: "the loss of potential gain from other alternatives when one alternative is chosen".

Looking at it one way, the loss of potential gain by picking B is 100 dollars, as that is the gain that would be had from doing A. However, by choosing B, not only are you missing out on 100 dollars, you're also losing 50 dollars by doing B itself. The difference in the gain between the two activities is 100 - - 50 = 150 dollars. This is the foregone value when activity B is chosen, and seems to give the full picture as to what is lost by choosing B. This term "The value foregone.." seems to appear in many definitions of opportunity cost online as well.

Different sites and sources seem to fall on either one side or the other. There are example questions and solutions online which show both methods of approach.

So, in an assignment which requires calculations of opportunity cost, which definition of opportunity cost will get me the marks- the value of the next best alternative, or the difference between the value of the next best alternative and the value of the chosen activity? Or both?

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  • $\begingroup$ Regardless of what answers you get, I'd like to point out the fact that you are obviously comfortable with switching back and forth between the definitions. I find the intuitive grasp that lets you switch back and forth more important than the definition. It shows that you get it. The only time the definition of opportunity cost will matter is when you use it with someone else, in which case check what definition they are using, because they might be using the "wrong" definition as well, and you will be able to adapt to their definition. $\endgroup$ – Cort Ammon Mar 8 '18 at 19:02
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    $\begingroup$ You might find this paper interesting: jfzuluaga.com/wp-content/uploads/CostoDeOportunidad.pdf $\endgroup$ – Ubiquitous Mar 8 '18 at 20:50
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Definition. The opportunity cost (OC) of any alternative is the value you place on the best of the forgone alternatives.

If we adopt the above definition (and I do), the OC of $B$ is the value of $A$, which is simply $\$100$.

With the above definition, the alternative you choose ($B$ in this case) is completely irrelevant when calculating its OC. All that matters is the best of the forgone alternatives.

To illustrate this point, consider this pair of examples:

Example #1. $A$ and $B$ are the only two alternatives. $A$: "Pay $\$500$ to get back $\$600$ in return." $B$: "Pay $\$500$ to get back $\$450$ in return." The OC of $B$ is the value of $A$, which is $\$100$.

Example #2. Everything is exactly the same as before, except that now $B$ is changed to "Pay $\$500$ to get back $\$1,000$ in return." The OC of $B$ is again the value of $A$, which is $\$100$.

In the above examples, the value of $B$ changes (from $-\$50$ to $\$500$) but that of $A$ doesn't. And so, the OC of $B$ is $\$100$ in both examples.

An alternative's value is completely irrelevant to its OC. What's relevant is the value of the best alternative forgone.

Notes. "What exactly is OC?"

This seemingly-simple question was discussed in the past (see e.g. Alchian, 1968). Then like many of the most important questions in economics, it was then forgotten/glossed over until Ferraro & Taylor (2005) and the susbequent literature spawned (see in particular the 2016 JEE Symposium).

It all boils down to which definition you use. My view (and I believe also that of Alchian and Buchanan, 1987) is that the above definition is the "most correct" one that "everyone should use". Of course, whoever's marking your homework may disagree.

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  • $\begingroup$ I've been trying to pinpoint the precise definition of opportunity cost recently. It seems, according to Mankiw, as well as your answer to a related question, that OC should be defined as the value of the best forgone alternative plus the explicit cost of the chosen alternative. Hence the opportunity costs in your two examples should have been \$600, i.e. the \$500 explicit cost and \$100 implicit cost. Am I right? $\endgroup$ – Herr K. Aug 13 '20 at 18:50
  • $\begingroup$ In mathematical terms, for $i\in\{1,2,\dots,n\}$, let $c_i$ and $v_i$ denote respectively the explicit cost and gross value of alternative $i$, and $u_i=v_i-c_i$ denote the net value of alternative $i$. Your currently stated definition would suggest that the opportunity cost of alternative $i$ is $$OC_i=\max\{u_j\}_{j\ne i}\,.$$ But your answer to the other question (and Mankiw's definition) would imply $$OC_i=\max\{u_j\}_{j\ne i}+c_i.$$ $\endgroup$ – Herr K. Aug 13 '20 at 19:01
  • $\begingroup$ @HerrK. I don't know what you are talking about. In each of my definition and examples, the opportunity cost is always the best of the forgone alternatives. $\endgroup$ – user18 Aug 14 '20 at 3:37
  • $\begingroup$ My confusion is: in your two examples, why did you not include the \$500 out-of-pocket explicit cost in calculating opportunity cost, while you said in your answer to a related question that "oppportunity cost includes all costs, including explicit out-of-pocket ones and any other implicit ones"? I think the value of the next best alternative refers only to implicit cost, but opportunity cost is more than implicit cost, according to your answer to the linked question. $\endgroup$ – Herr K. Aug 14 '20 at 4:48
  • $\begingroup$ In either Example #1 or #2, the value of alternative $A$ is $\$600 - \$500 = \$100$. I have taken into account the $\$500$ cost. I still don't know what you are talking about. $\endgroup$ – user18 Aug 14 '20 at 4:53
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Opportunity cost is what you forgo for choosing something else. Commonly thought of in economic terms as follows:

Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up.

The term is, as above, used when thinking about investments or purchases. Therefore, you can have a negative or positive investment return or outcome, or a monetary cost or gain.

If you spent 50 dollars which meant that you could not gain 100 dollars, your opportunity cost is 100 dollars. If you gained 100 dollars but instead you did not lose 50 dollars, your opportunity cost is negative 50 dollars (there's no opportunity cost for taking the 100 dollars, as the opportunity cost is negative). It was worthwhile that you obviously didn't lose the 50 dollars. You may claim that it's of value to lose the most money and in that case having the largest negative opportunity cost is the best. But that's a bit nonsensical.

The total opportunity cost isn't 150 dollars because we’re only interested in the forgone investment or monetary opportunity (the 100 dollars or negative 50 dollars.

Opportunity cost is about what you could gain or lose (but what we could have gained is more often used when opportunity costs are calculated) because you sacrificed or spent money on something else. There's really an infinite number of things you could bring into the opportunity cost equation. You don't work so you can paint art; you buy a house but can’t go overseas on a trip; and so on. Not everything can be thought of in strict economic terms, so opportunity cost is best left to discussions about monetary investments. Otherwise, this discussion will tie into what you value, and what provides you with the most utility. In that sense, there’s no right or wrong to it. What you see as a gain may be an absolute ’waste’ to others; therefore, your opportunity cost and another persons opportunity cost may vary wildly. That's why, again, it’s clearest to only stick to monetary investments and purchases when thinking about economic opportunity cost.

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As other answers clarified, the Opportunity Cost has been defined as the value of the best alternative foregone.
Assume that the gain in activity B will be positive, say USD 20. This too does not affect the Opportunity Cost, it does not make it equal to $100-20 = 80$.

In other words, the Opportunity Cost does NOT reflect the "net change of financial position if a switch from my current choice to the alternative". This would be, well, "net change in financial position", not opportunity cost.

Of course, these are labels, and one could conceivably go on and define "opportunity cost" in some other way. What I am writing here is what is its historically established definition in Economics.

Is it a "reasonable" definition? It is, if one realizes that it essentially respects the distinction between "cost (foregone direct gain) from NOT undertaking activity A", and "direct cost/gain by undertaking activity B". These are two different things conceptually, so it is reasonable to have a concept that does not net their effect.

So, again, It is NOT the full/net cost/gain of a choice.

Think also about the following: assume that there are only these two activities, and you can undertake both. What is the Opportunity Cost of choosing both? Answer: Zero. What is the total cost/gain of undertaking both? Answer 100-50 = 50.

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