THE JOURNAL OF ECONOMIC EDUCATION

, VOL. , NO. ,
http://dx.doi.org/./..

CONTENT ARTICLE IN ECONOMICS

Opportunity cost and the intelligence of economists: A comment

Daniel G. Arce
Department of Economics, University of Texas at Dallas, Richardson, TX, USA

In his interesting article, Professor Parkin contrasts forgone physical quantities with forgone values as
measures of the opportunity cost of basic economic decisions. The impetus for his study stems from an
experiment conducted by Ferraro and Taylor (2005), in which professional economists could not reach a
consensus over four alternatives presented as the opportunity cost of attending an Eric Clapton concert.
As F. Scott Fitzgerald (1936) put it in The Crack-Up, the test of a first-rate intelligence is the ability
to hold two opposite and opposing ideas in the mind at the same time, and still retain the ability to
function (p. 41). In this way, Potter and Sanders (2012) contended that every answer option provided
by Ferraro and Taylor (2005) is economically defensible, depending upon opportunity cost accounting
methodologies. In my mind, what matters is whether the decision makers involved are making apples-
to-apples comparisons in terms of the data available used to measure what is being chosen and what
is being forgone. Potter and Sanders called this operational standardization. Professor Parkin offers
several examples in which the physical quantity of what is being chosen and what is being forgone is a
better operational standard. In this comment, I show how values are the natural operational standard
for measuring opportunity costs when it comes to (a) shadow prices and (b) deriving economic profit.
Hence, both values and quantities have their place as measures of opportunity cost. Moreover, I argue
that the real issue is that textbooks should have an expanded set of examples of opportunity cost, many
more than they currently have.

Preliminaries
It is my impression that Ferraros and Taylors (2005) findings arise because their approach to opportu-
nity cost differs from the standard textbook treatment in that their data allow for a comparison of NET
benefits. In going to a Clapton concert, most textbook treatments would provide the datum that you
would be willing to pay $50 to see Dylan instead (the forgone alternative), but Ferraro and Taylor go
further than most textbooks in providing the cost of a Dylan ticket ($40), thereby making the forgone
net benefit equal to $50 $40 = $10. By contrast, the textbook case of the opportunity cost of a college
education typically focuses on what one might have earned by taking a job rather than pursuing ones
studies, but does not consider the net consequences of getting a job instead (e.g., restaurant vs. dorm
food, doctor bills instead of the student health center). Furthermore, the opportunity costs that stem
from ratios such as the slopes of the production possibilities frontier, budget constraint, and indifference
curves again measure marginal tradeoffs without net benefit calculations.

Opportunity cost: Shadow prices

The literature surrounding Ferraro and Taylor (2005) is almost unanimous in bemoaning how little
emphasis graduate texts in economics place on opportunity cost. My observation is that if opportunity
cost is addressed at all, it is through the relationship between opportunity cost and the shadow price of

CONTACT Daniel G. Arce darce@utdallas.edu Department of Economics, University of Texas at Dallas, West Campbell Road,
Richardson, TX , USA.
Taylor & Francis
24 D. G. ARCE

an activity. Shadow prices are invariably marginal values. Moreover, the Lagrange multipliers used in
constrained optimization constitute shadow prices and hence measure (marginal) opportunity costs. In
particular, the shadow price (Lagrange multiplier) of a resource measures the effect of a one-unit change
in the resource on the value of the objective function. Note the lack of ambiguity in the shadow price
treatment of opportunity cost as a value.
This interpretation is not altogether different from the analysis that accompanies Professor Parkins
figure 1, until he extends his analysis from perfect competition to monopoly. The associated analysis of
monopoly is well-known in trade theory, but I believe that it is a red herring when it comes to the current
debate. Specifically, the PPF in his figure 1 represents the productive capacity of an economy in autarky,
and the indifference curves in figure 1 are, in actuality, community indifference curves (Melvin and Warne
1973). To wit, individual decision making at the margin is not taking place in Parkins figure 1.1

P vs. Q vs. P Q
If P is the price of a good and Q is the physical quantity, then from the consumers perspective,
P Q is the associated expenditure, and from the firms perspective, P Q is the associated revenue.
In either case, P Q is a value and is fundamentally different from what either P or Q measures on its
own. Indeed, in recognition of this, most textbooks put a firms total revenue curve in a diagram that
is separate from the firms demand curve.2 Both diagrams have the same physical quantity, Q, on the
horizontal axis, but P is on the vertical axis of the demand curve, and P Q is on the vertical axis of
the total revenue curve. Consequently, in making economic decisions involving revenue, values are the
natural operational standard for opportunity cost. By the law of demand, in order to sell an additional
unit of a good, a firm must decrease its price, but this decrease in price is not the opportunity cost of
selling one more unit. Instead, given P < P and Q > Q, one must know P Q versus P Q. That is,
values matter. Neither the comparison of P versus P or Q versus Q suffices.
Does the P Q versus P Q comparison suffice? Economists are ultimately interested in (economic)
profit, not revenue. By its standard definition, economic profit is accounting profit less opportunity cost.3
Increasing quantity implies a reallocation of productive resources. What is the opportunity cost of this
reallocation? It most certainly entails an associated cost of capital necessary for additional production.
A firm operating on its production possibilities frontier also must cut back on the production of another
good, and so forgoes the revenue associated with that good. When does the process of calculating the
opportunity cost end? As Knight (1921) recognized in Risk, Uncertainty and Profit, it is difficult to carry
the concept of economic profit to the point of theoretical completeness.
One can see how values naturally serve as the operational standard for determining economic profits
through the following example. Southwest Airlines is justifiably proud of its record of profitability. During
the first quarter of 2008, Southwest spent $300 million on jet fuel at a hedged price of $60 a barrel. At
the same time, Southwests competitors paid spot prices of around $115 a barrel for jet fuel. During that
quarter, Southwests accountants reported a profit of $34 million. What were Southwests economic profits
during the same quarter?
In terms of opportunity cost, Southwest could conceivably sell the fuel it bought at the $60 hedge price
for the $115 spot price. The quantity of jet fuel matters as well; hence, opportunity cost is about the value
forgone. Under the hedge, Southwest was spending $300 million at $60 a barrel, so it was purchasing
5 million hedged barrels of jet fuel. In making its $34 million when the spot price was $115 a barrel,
Southwest lost the opportunity to instead make $275 million by selling the 5 million barrels. Notice
how this is an opportunity cost calculation similar to the net calculation in Ferraro and Taylor (2005).
Southwests opportunity costs are not $115 5 m = $575 m because it also has to cover the $60/bbl. cost
of acquiring the 5m barrels of jet fuel. The net value of the next best forgone alternative is used.
In this example, by using the fuel, Southwest forfeited a quarterly profit that was larger than its
declared annual profits for 2008 and 2009 combined. Southwests shareholders should have been con-
cerned because its economic profit = accounting profit minus opportunity cost = $34 million $275
million = $241 million (a loss). Southwest was not charging high enough ticket prices to cover the
opportunity cost of fuel. Both the quantity and price of jet fuel matter. A lower spot price (or a higher
 OPPORTUNITY COST AND INTELLIGENCE 25

hedge price) or a lower hedged quantity could have put Southwest in the black in terms of economic prof-
its, but its economic profits would still have been lower than Southwests declared profits. Determining
by how much requires a value calculation.

What is the real issue here?

In over 25 years of teaching principles of economics, I have used at least 10 different textbooks and cannot
recall a single student expressing concern that the textbooks treatment of opportunity cost was ambigu-
ous, nor have I had any difficulties with how opportunity cost is operationalized in the associated test
banks. What I have had trouble with is the dearth of examples in textbooks and test banks. Opportunity
cost is a major takeaway in principles of economics and in managerial economics for MBAs.4 Yet, I can
think of no textbook in either area in which the coverage of opportunity cost would sustain even half a
lecture.5 With consulting firms earning millions of dollars calculating economic profits for their clients
(where the hard work is in identifying opportunity costs), how can this be? This is compounded by the
virtual absence of any discussion of opportunity cost in undergraduate and MBA textbooks coverage of
marginal decision making (e.g., utility maximization, cost minimization, and profit maximization) and
a similar lack of material on marginal decision making when opportunity cost is covered.
The Ferraro and Taylor (2005) episode makes for an interesting sidebar in the treatment of opportu-
nity cost, but I believe that the real issue is that opportunity cost deserves much more attention than it
currently receives in textbooks. A collection of opportunity cost examples along the line of Byrns and
Stones (1989) long-out-of-print compilation of pedagogical techniques for undergraduate economics
would be most welcome.

Notes
1. From the perspective of individual decision making, Parkins figure 1 could be reinterpreted in terms of Fishers (1906)
separation hypothesis. In this case, however, the owner/manager would always be operating on a budget constraint
(isoprofit curve) that is tangent to the PPF. Under perfect competition, the price ratio, PX /PY , is taken as given. If the
market for X is monopolistic, the owner selects the profit-maximizing price, which is greater than the price associated
with perfect competition (marginal cost) and increases the production (quantity supplied) of X owing to this increase
in price. Under imperfect competition, the owner sets a price that is the best reply to the prices of competitors.
2. Although one could imagine a bubble diagram in which the largest revenue bubble would occur at the (quantity, price)
midpoint of a standard linear demand curve.
3. In consultant-speak, economic profit is also known as economic value added or return on investment/assets.
4. In Maitals (1992) survey of graduates of MITs management of technology program, the six economic concepts found
to be most useful were (in order of importance) present value, learning curves, sunk cost, opportunity cost, economies
of scale and scope, and marginal cost.
5. My familiarity with the content of these texts is initially documented in Arce (2004).

References
Arce, D. G. 2004. Conspicuous by its absence: Ethics and managerial economics. Journal of Business Ethics 54 (3): 26177.
Byrns, R. T., and G. W. Stone, eds. 1989. Great ideas for teaching economics. 4th ed. Glenview, IL: Scott, Foresman and
Company.
Ferraro, P. J., and L. O. Taylor. 2005. Do economists recognize an opportunity cost when they see one? A dismal performance
from the dismal science. Contributions to Economic Analysis and Policy 4 (1): Article 7, December.
Fisher, I. 1906. The nature of capital and income. New York: MacMillan.
Fitzgerald, F. S. 1936. The crack-up. Esquire, February, 4147.
Knight, F. H. 1921. Risk, uncertainty and profit. Chicago: University of Chicago Press.
Maital, S. 1992. What do economists know that managers of technology find useful? Journal of Economic Education 23 (2):
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Melvin, J. R., and R. D. Warne. 1973. Monopoly and the theory of international trade. Journal of International Economics 3
(2): 11734.
Parkin, M. 2016. Opportunity cost: A reexamination. Journal of Economic Education 47 (1): 1222.
Potter, J., and S. Sanders. 2012. Do economists recognize an opportunity cost when they see one? A dismal performance
or an arbitrary concept? Southern Economic Journal 79 (2): 24856.
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