Division of Labour: Opportunity Cost

September 02, 2005

Opportunity Cost

My graduate school colleague Laura Taylor was cited in Robert Frank's NYT column yesterday:

Virtually all economists consider opportunity cost a central concept. Yet a recent study by Paul J. Ferraro and Laura O. Taylor of Georgia State University suggests that most professional economists may not really understand it. At the 2005 annual meetings of the American Economic Association, the researchers asked almost 200 professional economists to answer this question:

"You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50."

Stunningly, more than 3/4 of economists--not just any Joe Blow economists but the high powered types who attend the AEA meetings--got the question wrong. Here's the correct answer:

The opportunity cost of seeing Clapton is the total value of everything you must sacrifice to attend his concert - namely, the value to you of attending the Dylan concert. That value is $10 - the difference between the $50 that seeing his concert would be worth to you and the $40 you would have to pay for a ticket. So the unambiguously correct answer to the question is $10.

Posted by E. Frank Stephenson at 10:59 AM in Economics · TrackBack (0)

Comments

I have received a couple of e-mail comments on this post. I will post them in two separate comments. I have read the comments, but I am only the messenger:

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As a pedagocal example, this is not a an advisable way to teach opportunity cost.

Opportunity cost is the highest valued alternative activity that one could have participated in, but chose not to.

In other words, the highest valued sacrifice involved in a given choice.

The problem with this example is that the example violates a basic premise. That is, it assumes that there is no cost for the Clapton ticket (i.e. it is "Free")

However, we teach our students that there is a cost to everything (there is no free lunch). That is the whole point to opportunity cost.

Consider an alternative way of interpreting this so as to get an answer of $50.

If someone gave me a free ticket, I might feel obligated to that person (i.e. this is a cost to me of getting a free ticket).

What value (or cost) do I place on the ticket that I am given? Well, I would look to the cost of a close substitute. The Dylan ticket has a price of $40. Hence, I might place a value of $40 on the Clapton ticket.

In this case the costs of both the Dylan and the Clapton will be $40.

The answer of $10 assumes that the cost of the Dylan ticket is $40 but the cost of the Clapton ticket is $0.

I still say there is no free lunch.

Given what I have just presented the opportunity cost would be $50 in the way that I have presented things.

Mark Wohar

Posted by: Craig at September 8, 2005 05:00 PM

"The problem with this example is that it violates a basic premise" ?!? And that's why you can't get the right answer to the question?

What if we asked physics professors a question like "Consider an object moving at 10 m/s across a frictionless surface ..." and every professor's gut reaction was to interrupt and say "But your question violates a basic premise of physics! There's no such thing as a frictionless surface!"? The first woodpecker that came along would destroy civilization.

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