Opportunity Cost: An Impractical Concept?

 

Opportunity cost is an enduring concept in economics. Mankiw’s Principles of Economics textbook would tell you: opportunity cost is the value of the next-best alternative when a decision is made. Simply put, if you’re buying a litre of petrol, you are foregoing the option to buy a kilo of mangoes. Or half a kilo of chicken. Or all the other seemingly endless possibilities of alternative purchases. In other words, it is the tradeoff we face in a world of scarcity.

The concept is intuitive and useful in thinking about many fields. By buying a $1,000 treasury bill, you are foregoing the potential of excess returns you could have earned investing the same amount in a stock market index or mutual fund. If the treasury bill was to give a return of 5% and the mutual fund a return of 9%, then mathematically the opportunity cost would be 4%. That is the value (return) an investor would forgo if they prefer less risk.

But do consumers think about opportunity costs nowadays when making decisions?

This question arises from the countless trips I’ve made to a khokha, kiryana or grocery store. In my observations, when people buy an item, they think of it in nominal terms: “I spent Rs 500 buying yoghurt”. They might ask the price of an item they want, but rarely cross-check the prices of other products or competing brands.

Without knowing the cost or value of alternatives, how can we say the consumer made a rational decision? Wouldn’t that render much of the textbook economic theory useless then?

In a barter economy, transactions and purchases can easily be thought of through opportunity cost. After all, when a person only has the option to either consume their produce or trade it for other goods in proportionate amounts, opportunity cost becomes a dominating concept. A farmer would surely weigh the options of what they can buy or trade for a gallon of milk their cows produced.

But, as the world moved to a monetary system of banknotes and fiat currency, a big change took place. The idea of buying products with money meant that the cost of buying a litre of petrol was thought of in monetary terms. A litre of petrol cost Rs 250 instead of a kilo of mangoes or half a kilo of chicken in the consumer’s mind. The link between a purchasing decision and its true opportunity cost has been lost.

The consequence of this has been the soaring consumerism observed globally over the last century. Although one must acknowledge that the expansion of consumer credit has also played a huge role in increasing consumerism. Still, the invention of money has made phenomenas like ‘impulse buying’ common and widespread.

Despite this, opportunity cost is a useful concept in understanding why or how consumers make decisions. Even if consumers are thinking a litre of petrol costs Rs 250, they still have a limited amount of income they can spend on a limited amount of goods. The inherent scarcity of resources pushes consumers to make decisions with opportunity costs even though they may not be consciously thinking about it.

But the consumers, investors, or policymakers who thoughtfully utilize opportunity costs can gain an edge in this world. They can squeeze out efficiencies and returns that may not seem possible on first glance.