Finance Discipline Group
UTS Business School
University of Technology, Sydney

Working Paper Series

Title:
Opportunities Lost and Regained in the Land of Opportunity Cost
Author(s): Rod O'Donnell
Date of publication: December 2010
Working paper number: 163
Abstract:
The economics profession, as a whole, has a gravely confused understanding of opportunity cost, a concept widely regarded as one of the most fundamental ideas of economics. The muddle arises because of the existence of two contrary conceptions of opportunity cost which are presumed to be the same but only one of which is correct. Conceptually, the problem is serious because, while the correct idea leads to analytical coherence, the incorrect one generates incoherence and chaos. The incorrect definition, which is arguably more prevalent, introduces mistakes into the treatment of opportunity cost in top-selling mainstream texts used in the US and in their offshoots in other countries. Fortunately, the problem can be eliminated by some judicious reconstruction. Full coherence can be restored to the conceptual framework by the retention of the term opportunity cost for the referent of the correct definition, and the introduction of a new term, trade-off cost, for the referent of the incorrect definition. The argument is based on a survey of the treatment of opportunity cost and its applications in well-known US texts written by prominent economists and experienced economics educators – thirteen introductory texts, five intermediate texts, four graduate texts and one applied research work. In those texts that mention opportunity cost, none work solely with the correct definition, a majority deploy both definitions simultaneously as if they were identical, and a minority are based entirely on the incorrect definition. The result is that millions of economics students and graduates world-wide are being given confused and deficient understandings of opportunity cost.
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