Cost of Opportunity (part 1 – framing effects)

Framed! by Rishi_S

Big HT2 Scott Sumner.

In a very good review of Tyler Cowen’s new book Create Your Own Economy (which I purchased but haven’t started to read yet) Sumner says in the comments (in reference to framing effects)

They remind me of a personal experience I had that I ask my class about. I bought a Springsteen ticket in 1978 for $10. As I was about to go in someone offered me $50. I ask people “what did it cost me to see the show?” Almost nobody says $50. Oddly, some people say $40. (They are also surprised by how cheap tickets were back then. It was a small show in a Chicago movie theatre. Very cozy. And in 1978 Springsteen was a very charismatic perrformer in an intimate setting.)

I understand the inclination to say the costs as $40. I posed this scenario to several non-economists and got an answer of either $10 or $40. Of course, $10 represents the sunk cost of the ticket and this is obvious. Once the ticket is purchased, there is no opportunity for resale and so no costs of opportunity. But the $40 profit represented by the scalper represents an opportunity cost: the potential gains foregone to pursue a preferred task. The total costs are, therefore, represented by the opportunity cost plus the sunk costs for a total of $50.

This is a confusing concept… why aren’t the sunk costs subtracted? Because the sunk cost (at least in this scenario) are non-refundable. I can’t can’t my initial $10 back, but forgoing the profit I could make from the ticket sale comes costs a $40 profit.

Of course, we must also consider non-monetary costs and benefits… If you consider a Springsteen concert experience more than even $50 in total costs. This makes opportunity costs different to express in real scales and on temporal scales. One commenter (known as “philo”) points this out on Sumner’s blog: opportunity costs are time scale relevant. Framing effects, available choices and preferences over a given time, are important.

Stay tooned: In my next post, I discuss opportunity costs further with fellow False Symmetry blogger, Robert Simione.

9 Comments  »

  1. Robert says:

    FIRST!

  2. azmyth says:

    The opportunity cost is calculated by comparing the value of possible actions. In this example, you have one possible action of going to the concert. The other possible action is selling the ticket and getting $50. At the moment when you are at the concert, these are your two options.

    Mankiw’s definition of opportunity cost is “what you give up to get that item.” Since you must give up having $50 to go into the concert, that is your opportunity cost. The opportunity cost would not change if you got the ticket for free or if you originally paid $500 for the ticket. The original price of the ticket is sunk and must be ignored.

    I don’t think I’m disagreeing with anything you say, I just found your explanation a little confusing and thought perhaps your readers would appreciate a restatement.

    • Zachary Kurtz says:

      thanks for the detailed explanation. No, I don’t think we’re disagreeing. The point I was trying to make was that the total costs are the sunk costs + opportunity costs (in this case, monetary profit given up).

      But the framing effects are important here. If I’m considering the day of the concert, the opportunity cost is indeed $50 (price of ticket scalping only). But, if I’m thinking intertemporally, including both the time of the ticket purchase and the concert, then the sunk costs are $10 and the profit opportunity given up is $40… bringing the total costs up to $50.

      Is there something wrong with this line of thinking?

      • azmyth says:

        Opportunity cost is a very different idea from total cost and profit because it is tied to a single point in time, and the possible actions at that moment in time. Information is also important, because it affects what the agent’s expected payoffs from various strategies are. When Scott first bought the ticket, he did not know the scalper would offer $50 or he would have bought several tickets, sold as many as the scalper would buy, and still gone to the concert for $10.

        As time goes by, the opportunity cost can change dramatically. At the time of the ticket purchase, the opportunity cost of buying the ticket was the possibility of a world where Scott had $10 more in his pocket. At the time of the concert, the opportunity cost of seeing the concert was a possibility of a world where Scott had $50 more in his pocket.

        I think a good way to calculate opportunity cost is to use a 2 step calculation. Calculate the net costs and benefits for each possible action, and then compare the results of each action. The net benefit of the second best action is the opportunity cost. It’s rather strange to call a forgone benefit a cost, and I think the terminology has confused a lot of people, but we’re stuck with it now. This blog has a good discussion of ways to look at opportunity cost, even though I disagree with the author’s conclusion. http://divisionoflabour.com/archives/001666.php

        • Zachary Kurtz says:

          Right (and this is a good summary) but is not the total costs at the time the scalper’s offer was made (and refused) = sunk costs + opportunity costs? Keeping in mind the original question was asking about total costs of going to the show… Unless I misread the original question, I think this ‘calculation’ makes sense.

          I’ll check out that post, thanks.

          • azmyth says:

            Ok, I read Scott’s post to mean opportunity cost and not total cost. I honestly don’t know how I’d calculate total cost in this situation. The problem with including opportunity costs in total costs is that there is theoretically no limit to the alternative actions one could take. What if there were 10 other scalpers offering $49, $48, etc. Would all of these opportunities forgone be included? I’m not sure.

            • Zachary Kurtz says:

              I don’t either (does anybody?). This is essentially what my post was (attempting) to complain about. It seems as I wasn’t as clear as I was hoping to be.

              • Azmyth, When Zach and I were talking about this, I suggested there is even one more hidden cost with this: the time you take out and set aside to go to the show is being sacrificed in some sense too, along with the dissappointment of canceling your plans for the evening. Though I think you guys have already covered this in the abstract sense.

      • Anton says:

        兄台則重 auditee side maitrtaliey 浪費很多時間去說服 是否應該看看這客戶的 maitrtaliey towards the audit firm 呢 既然是 Big4內審 客戶細極有限 亦不想得罪客戶 不過也不應太浪費時間 只要做好內審的工作 meet all fiduciary duties 也要照顧自家的 Cost effectiveness!哈哈哈 派個 senior manager 上去講解 charge $1,500 一個 time slot 15min

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