How is “opportunity cost” an useful concept? Even when it does exist?

Question

How is "opportunity cost" an useful concept? Even when it does exist?

What use does it serve?

Answer 1

Probably the most useful aspect of the concept of "opportunity cost" is to distinguish between choice problems where a particular choice is available, but the alternatives differ. The concept of opportunity cost stresses that when we make a choice of some action, we forego alternatives, and so the gain from that action is the difference between the benefit of that action, and the benefit of the next-most-preferred alternative.

For example, you might have two choice problems (e.g., two nights of the week) where you have the opportunity to go to the movies on your own. You get a certain amount of enjoyment from this, and so you might consider making this decision by thinking about how much you enjoy this activity. The concept of opportunity cost would tell you to bear in mind the available alternatives, so that you remember you are foregoing other possible activities if you choose to go to the movies. In one of these cases (e.g., the first night) you might not have any exciting alternatives, and so going to the movies is pretty attractive (the opportunity cost is low). However, on another night, you might have been invited to an exciting party, with lots of close friends, and so now going to the movies and missing the party seems like a relatively bad idea (the opportunity cost is high).

All that "opportunity cost" is really doing is reminding you of the fact that decision problems must be considered on the basis of all the available actions, and the relative value of the optimal action is affected by the value of the best foregone alternative. Most people understand this implicitly (for the most part), but economists are particularly aware of this, and have developed a concept around it.

One consequence of considering opportunity cost is to highlight the sunk cost fallacy, where a person makes a decision to pursue some action even though it is less desirable than the available alternatives, because they have already committed resources to that course of action, and they do not wish to accrue losses from a change of action (i.e., they have loss aversion). In the example above, suppose you had already pre-paid for your movie-ticket before you find out about the party, and you can't get a refund. The payment you made for the ticket is a "sunk cost". You might be inclined to go to the movies, and miss the party, just so that you don't "waste" the money on the ticket. However, doing this would just compound one mistake (buying the ticket) with another mistake (choosing to see the movie over a party you would have enjoyed more). The concept of opportunity cost tells you to compare the available actions against the alternatives, noting that the sunk cost occurs under every case (and is therefore not relevant to a particular action).