Lecture Notes: Opportunity Cost and Cost-Benefit Analysis

Introduction

• Lecturer: Jacob Reed from ReviewEcon.com
• Topic: Opportunity Cost and Cost-Benefit Analysis
• Resources: Total Review Booklet at ReviewEcon.com

Opportunity Cost

• Definition: Value of the next best alternative not chosen.
• Associated with every choice, emphasizes that nothing is free (acronym: TANSTAAFL - There Ain't No Such Thing As A Free Lunch).
• Synonym for 'cost' in AP Microeconomics.

Types of Costs

• Explicit Costs: Money paid directly for a choice (e.g., movie ticket, popcorn).
• Implicit Costs: Lost earnings or value of other opportunities (e.g., wages not earned due to going to a movie).

Calculating Opportunity Cost

• Formula: Explicit Costs + Implicit Costs = Total Opportunity Cost
• Example: Going to a movie
  • Movie ticket: $20 (explicit)
  • Popcorn: $10 (explicit)
  • Lost wages: $60 (implicit)
  • Total Opportunity Cost: $90

Non-Relevant Costs

• Retail value not paid (e.g., ticket's full price if discounted is irrelevant)
• Costs incurred regardless of choice (e.g., gas expenses if they are the same for all choices)
• Less optimal alternatives not chosen (e.g., babysitting for $40 vs. working for $60).

Practice Example

• Problem: Peggy Smith’s opportunity cost of going to college
  • Explicit cost: Tuition and fees - $4,600
  • Implicit cost: Lost wages - $12,000
  • Total Opportunity Cost: $16,600 annually

Application to Production Possibilities Curve (PPC)

• Moving from one point to another on the PPC involves opportunity cost.
  • Example: Moving from 65 capital goods and 35 consumer goods to 30 capital goods and 75 consumer goods results in a loss of 35 capital goods to gain 40 consumer goods.

Cost-Benefit Analysis

• Components: Total Cost (opportunity cost), Total Benefit (enhancement to well-being), Total Net Benefit (Total Benefit - Total Cost)
• Rational Decision Making: Act when Total Benefits > Total Costs (positive net benefit)
  • Example 1: Building a park
    • Cost: $1 million
    • Benefit: $1.5 million
    • Net Benefit: $0.5 million (positive)
  • Example 2: Getting a haircut
    • Cost: $20
    • Benefit: $15
    • Net Benefit: -$5 (negative)

Conclusion

• Overview of opportunity cost and cost-benefit analysis.
• Next topic: Marginal Analysis.
• Practice resources at ReviewEcon.com.
• Additional help: Total Review Booklet at ReviewEcon.com.