Economics Asked by Richard Hardy on July 11, 2021
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 @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.
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.
Answered by 1muflon1 on July 11, 2021
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