In the last article we covered total benefit and marginal benefit. Today we look at how these two concepts shape our everyday decisions — and then we can finally introduce opportunity cost.
In economics, we assume every consumer can make rational decisions. Being rational means maximising the value of our resources. In everyday terms, a rational consumer makes the most of their money: after weighing its different possible uses, they choose the option that brings the greatest benefit. Our daily decisions therefore tend to follow total benefit, picking whichever option ranks first. But that is not quite the full story — different options carry different costs, so besides benefit we should also consider the cost of each option. Suppose we are choosing a flat to rent: one is well connected and very close to work; the other is less convenient and some distance from the office. Comparing benefits alone, the first is clearly better — yet in real life we do not always choose it. The main reason: the first flat's rent is usually much higher, and once we balance benefit against cost, we may well choose the second.
In economics, cost is defined as the highest-valued option forgone when making a decision. In the renting example, if our salary is limited and we cannot rent both flats, choosing either one means giving up the other. This goes back to scarcity: because resources are limited and cannot satisfy all our wants, every decision under scarcity involves a trade-off — choosing one option means at least one other option is given up. We measure the value of the forgone option and treat it as the cost of the decision. Most decisions involve two kinds of cost: explicit cost and implicit cost. Explicit cost is an outlay that is easy to observe — in modern society, usually money paid. Implicit cost is the forgone opportunity of the resources used. In past public exams, students have typically referred to these as money cost and time cost.
Cost: the highest-valued option forgone when making a decision. Total cost comprises explicit cost and implicit cost. 1. Explicit cost: an easily observed outlay, usually called money cost. 2. Implicit cost: the forgone opportunity of the resources used, usually called time cost.
Putting the two together: a rational consumer chooses decisions whose benefit is greater than or equal to their cost. Returning to our example, whether to rent the convenient flat or the cheaper one often depends on the renter's costs. For a company executive with a high salary whose time is needed for important work, the benefit of renting near the office outweighs the cost, so they choose the convenient flat. But for a newly hired junior employee with a lower salary and no pressing demands on their time, the cheaper flat becomes more attractive — for them, the first flat's cost exceeds its benefit, while the second's benefit exceeds its cost, and the rent saved can be used elsewhere.
Rational decision: a decision whose benefit is greater than or equal to its cost.
More precisely, the benefit and cost in a rational decision refer to marginal benefit and marginal cost. We covered marginal benefit earlier; marginal cost is the extra cost incurred by making a decision. So when deciding, any cost that must be paid whether or not we go ahead should not be taken into account. A classic example is a cinema ticket we have already bought: buying it involved money cost, but if we are now deciding whether to go and watch the film, that money is spent either way. Since this cost does not change with our decision, it should not factor into it.
Rational decision: a decision whose marginal benefit is greater than or equal to its marginal cost.
In the next article, we will look in more detail at how benefit and cost shape our decisions, with everyday examples and past exam questions to make both concepts even clearer.
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