<p>Omitting opportunity cost can lead to different outcomes. Consider a trivial example:</p>
<p>You can set up a business with revenue \$1000 and costs \$500 making your <em>accounting</em> profit \$500. Now suppose your second best choice to setting up the business is to become an accountant where you could earn net salary of \$750. This forgone salary becomes your opportunity cost since following Buchanan (1991) opportunity cost is simply:</p>
<blockquote>
<p>the
evaluation placed on the most highly valued of the rejected alternatives or
opportunities. It is that value that is given up or sacrificed in order to secure the
higher value that selection of the chosen object embodies.</p>
</blockquote>
<p>If you ignore opportunity cost you record \$500 <em>accounting</em> profit, but if you calculate <em>economic</em> profit by including opportunity cost of forgone salary you will find that your economic profit is -\$250.</p>
<p>This would change your decision as in a long run you should not pursue a project that yields negative profit (if you are rational profit maximizing agent). So in this case you will take the option of not to undergo the project if you correctly account for opportunity cost, but if you omit it you will incorrectly pursue the project as it seemingly yields positive profit.</p>

CC BY-SA 4.0
2021-06-14T15:41:38.563Z
Thank you for a simple and clear answer! Perhaps I was not clear enough in my formulation, but I would definitely consider becoming an accountant as one of the possible projects. If we have this possibility in our universe, it has to be evaluated alongside all other projects. Now with that out of the way, could we get rid of alternative costs in project evaluation?
Richard Hardy
CC BY-SA 4.0
2021-06-14T16:12:54.170Z
@RichardHardy It would still change the profit calculation for each individual project. In some simple scenario with discrete choice between some simple choices it might make no difference but in some more complex scenarios it might. For example, suppose that in order to do anything in the example above you need to earn at least \$300 because your utility function is such that for taking no action and enjoying free time you receive utility equal of \$300. In the scenario above accounting profit of running business is \$500 accounting business of working is \$750, but economic
1muflon1
CC BY-SA 4.0
2021-06-14T16:14:20.367Z
profits are -\$250 and \$250 respectively. If you need to earn at least \$300 to be compensated for the fact that you do something as opposed to enjoying leisure than it would change the decision as now none of the actions exceed the threshold.
1muflon1
CC BY-SA 4.0
2021-06-14T17:33:17.543Z
the main complication seems to be introduction of another alternative (leasure) and putting a utility function on top of the monetary outcomes. My response would be, include all alternatives/projects in the comparison (leasure, business, accounting), obtain their monetary outcomes (\$300 equivalent, \$500, \$750), turn into utilities ($u_1$, $u_2$, $u_3$), and pick the one with maximum utility. The problem should be solved. Or is that not possible? Also, I lost you at how the economic profits are \$-250 and \$250. How did you get those numbers?
Richard Hardy
CC BY-SA 4.0
2021-06-14T17:37:55.313Z
Also, I am not sure if you meant to measure utility of the increments in wealth and leisure or the utility of total wealth and leisure, but again I do not see a conceptual difficulty with either of these. It seems that fundamentally we are dealing with the same information but presented in a different way, e.g. something equivalent to $a$ vs. $b$ vs. $c$ (my approach) or $a-c$ vs. $b-c$ vs. $c-b$ (alternative cost approach) for some set of alternatives with utility outcomes or perhaps just monetary outcomes $a<b<c$.
Richard Hardy
CC BY-SA 4.0
2021-06-14T17:54:16.223Z
@RichardHardy Economic profit is all revenue minus all cost (including opportunity cost), so for business revenue is 1000 cost 500 and opportunity cost another 750 yielding -250. For working you earn 750 and the next best alternative is running the business with profit 500 (which becomes opportunity cost) so profit from that activity is 250. Thats where the numbers come from.
1muflon1
CC BY-SA 4.0
2021-06-14T18:00:20.910Z
@RichardHardy I had in mind some situation where person would face utility function such as $U=(x-300)^{0.5}$, but then consider this example. Suppose that monopolist faces **accounting** profit $\Pi = (a-q)q -cq$ where we exclude per unit oppor. cost $o$. Without opportunity cost you would select optimum quantity $q^*= (a-c)/2$ but that quantity, is incorrect profit maximizing quantity since the correct one taking account for opportunity cost would be $q^*=(a-c-o)/2$ if you consider different possible quantities of q as a different projects you would get wrong answer without opportunity cost
1muflon1
CC BY-SA 4.0
2021-06-14T18:56:27.210Z
Sorry if I am stupid, but I do not really see a fundamental difference between the approaches here either. I suppose if I calculated the final monetary (or if you like, utility) values of all possible projects (all possible production quantities) and the other project (to which the opportunity cost is due), my gut feeling tells me I would arrive at the correct optimal choice. We do not have all the details here, but if we did, I think I would be able to provide a solution that does away with opport. cost. This is because of what I said in my previous comment. Anyway, +1 for a good discussion.
Richard Hardy
CC BY-SA 4.0
2021-06-14T19:04:37.847Z
@RichardHardy well there might not be difference in some simple discrete choice setting but in a more complex one like with that with quantity there is a difference.  For example, let us assume $a=100$ $c=20$ and $o=30$ let us suppose $q$ measures number of oil tankers produced. Without OC you get production $q^∗=(a−c)/2 = (100-20)/2 =40$  while with OC $(a-c-0)/2=(100-50)/2=25$ That is whooping difference of 15 oil tankers that would not be trivial and here recalculation in terms of utility would not matter, here the problem involves actual production
1muflon1
CC BY-SA 4.0
2021-06-14T20:29:51.833Z
Thank you. I will analyze you example and see if I may come up with an equivalent solution without explicitly using OC.
Richard Hardy
CC BY-SA 4.0
2021-06-14T15:29:32.843Z
2021-06-14T15:29:32.843Z
1muflon1
<p>When evaluating a business project, a textbook recipe is to take incremental income from the project and subtract the incremental costs -- including opportunity costs -- to arrive at the incremental result*. When choosing among competing projects, one compares the incremental results and chooses the project with the highest one, <em>ceteris paribus</em>.</p>
<p>I am a little bothered by the treatment of opportunity costs here. I also think there is a conceptually simpler alternative**. I wonder what, if anything, could go wrong if we first evaluated each possible project (in the broadest possible sense so as to include everything the business owner could do with his/her resources***) without subtracting opportunity costs and then compared the results across projects. Would that possibly yield a different result?</p>
<p>*<em>Incremental result</em> and such is probably not the standard terminology. Feel free to suggest how to rephrase in standard terms.<br />
**What is conceptually simple vs. difficult can of course be debated.<br />
***This has been edited in response to the example of @1muflon1. I count becoming an accountant as one of the projects under consideration. If this thought/project is in our universe, it has to be evaluated alongside all the other alternative projects.</p>

<opportunity-cost>
When choosing among alternative projects, must one always adjust for opportunity cost?
Richard Hardy
# When choosing among alternative projects, must one always adjust for opportunity cost?

(Asked by: username_0 on 2021-06-14)

When evaluating a business project, a textbook recipe is to take incremental income from the project and subtract the incremental costs -- including opportunity costs -- to arrive at the incremental result\*. When choosing among competing projects, one compares the incremental results and chooses the project with the highest one, *ceteris paribus*.

I am a little bothered by the treatment of opportunity costs here. I also think there is a conceptually simpler alternative\*\*. I wonder what, if anything, could go wrong if we first evaluated each possible project (in the broadest possible sense so as to include everything the business owner could do with his/her resources\*\*\*) without subtracting opportunity costs and then compared the results across projects. Would that possibly yield a different result?

\**Incremental result* and such is probably not the standard terminology. Feel free to suggest how to rephrase in standard terms.  
\*\*What is conceptually simple vs. difficult can of course be debated.  
\*\*\*This has been edited in response to the example of @username_1. I count becoming an accountant as one of the projects under consideration. If this thought/project is in our universe, it has to be evaluated alongside all the other alternative projects.

**Tags:** opportunity-cost


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## 1 answers

### Answer by username_1 on 2021-06-14. Score: 1

Omitting opportunity cost can lead to different outcomes. Consider a trivial example:

You can set up a business with revenue \$1000 and costs \$500 making your *accounting* profit \$500. Now suppose your second best choice to setting up the business is to become an accountant where you could earn net salary of \$750. This forgone salary becomes your opportunity cost since following Buchanan (1991) opportunity cost is simply:

> the
> evaluation placed on the most highly valued of the rejected alternatives or
> opportunities. It is that value that is given up or sacrificed in order to secure the
> higher value that selection of the chosen object embodies.

If you ignore opportunity cost you record \$500 *accounting* profit, but if you calculate *economic* profit by including opportunity cost of forgone salary you will find that your economic profit is -\$250.

This would change your decision as in a long run you should not pursue a project that yields negative profit (if you are rational profit maximizing agent). So in this case you will take the option of not to undergo the project if you correctly account for opportunity cost, but if you omit it you will incorrectly pursue the project as it seemingly yields positive profit.

> **Comments:**
> **username_0**: Thank you for a simple and clear answer! Perhaps I was not clear enough in my formulation, but I would definitely consider becoming an accountant as one of the possible projects. If we have this possibility in our universe, it has to be evaluated alongside all other projects. Now with that out of the way, could we get rid of alternative costs in project evaluation?  
> **username_1**: @username_0 It would still change the profit calculation for each individual project. In some simple scenario with discrete choice between some simple choices it might make no difference but in some more complex scenarios it might. For example, suppose that in order to do anything in the example above you need to earn at least \$300 because your utility function is such that for taking no action and enjoying free time you receive utility equal of \$300. In the scenario above accounting profit of running business is \$500 accounting business of working is \$750, but economic  
> **username_1**: profits are -\$250 and \$250 respectively. If you need to earn at least \$300 to be compensated for the fact that you do something as opposed to enjoying leisure than it would change the decision as now none of the actions exceed the threshold.  
> **username_0**: the main complication seems to be introduction of another alternative (leasure) and putting a utility function on top of the monetary outcomes. My response would be, include all alternatives/projects in the comparison (leasure, business, accounting), obtain their monetary outcomes (\$300 equivalent, \$500, \$750), turn into utilities ($u_1$, $u_2$, $u_3$), and pick the one with maximum utility. The problem should be solved. Or is that not possible? Also, I lost you at how the economic profits are \$-250 and \$250. How did you get those numbers?  
> **username_0**: Also, I am not sure if you meant to measure utility of the increments in wealth and leisure or the utility of total wealth and leisure, but again I do not see a conceptual difficulty with either of these. It seems that fundamentally we are dealing with the same information but presented in a different way, e.g. something equivalent to $a$ vs. $b$ vs. $c$ (my approach) or $a-c$ vs. $b-c$ vs. $c-b$ (alternative cost approach) for some set of alternatives with utility outcomes or perhaps just monetary outcomes $a<b<c$.  
> **username_1**: @username_0 Economic profit is all revenue minus all cost (including opportunity cost), so for business revenue is 1000 cost 500 and opportunity cost another 750 yielding -250. For working you earn 750 and the next best alternative is running the business with profit 500 (which becomes opportunity cost) so profit from that activity is 250. Thats where the numbers come from.  
> **username_1**: @username_0 I had in mind some situation where person would face utility function such as $U=(x-300)^{0.5}$, but then consider this example. Suppose that monopolist faces **accounting** profit $\Pi = (a-q)q -cq$ where we exclude per unit oppor. cost $o$. Without opportunity cost you would select optimum quantity $q^*= (a-c)/2$ but that quantity, is incorrect profit maximizing quantity since the correct one taking account for opportunity cost would be $q^*=(a-c-o)/2$ if you consider different possible quantities of q as a different projects you would get wrong answer without opportunity cost  
> **username_0**: Sorry if I am stupid, but I do not really see a fundamental difference between the approaches here either. I suppose if I calculated the final monetary (or if you like, utility) values of all possible projects (all possible production quantities) and the other project (to which the opportunity cost is due), my gut feeling tells me I would arrive at the correct optimal choice. We do not have all the details here, but if we did, I think I would be able to provide a solution that does away with opport. cost. This is because of what I said in my previous comment. Anyway, +1 for a good discussion.  
> **username_1**: @username_0 well there might not be difference in some simple discrete choice setting but in a more complex one like with that with quantity there is a difference.  For example, let us assume $a=100$ $c=20$ and $o=30$ let us suppose $q$ measures number of oil tankers produced. Without OC you get production $q^∗=(a−c)/2 = (100-20)/2 =40$  while with OC $(a-c-0)/2=(100-50)/2=25$ That is whooping difference of 15 oil tankers that would not be trivial and here recalculation in terms of utility would not matter, here the problem involves actual production  
> **username_0**: Thank you. I will analyze you example and see if I may come up with an equivalent solution without explicitly using OC.  

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