Scarcity, Opportunity Costs, and Decision Making
When it comes to understanding decision making, perhaps the most fundamental concept is that of opportunity cost. It is one of the most important concepts in economics, and I would argue, in life in general.
Before we can understand opportunity costs, we first need to examine the concept of scarcity. If you look around the world, you will find that there is a finite amount of “stuff”. There are only so many precious minerals in the ground, and only so many authentic Babe Ruth baseball cards floating around. Companies have limited budgets, and individuals have only 24 hours in a day to accomplish the things they need to do. A fundamental fact about the world is that we all have limited resources which we can use to pursue our various ends and objectives. If you’ve ever thought, “There just aren’t enough hours in the day to do all of the things I need to do”, then you’ve experienced scarcity.
Since resources are scarce, that means that not every demand can be satisfied. Since we have a multitude of wants but limited resources to attain them, scarcity forces us to economize, i.e., to apply our resources in such a way as to satisfy as many of our wants as we can. Scarcity forces us to find ways to get the “biggest bang for our buck”. For instance, a company with a certain R&D budget cannot pursue every project proposal – they have to weigh the costs and benefits of each one and select a portfolio that maximizes their expected return. Of course we can be wrong in our assessments of potential costs, payoffs, probabilities of success, etc. But that doesn’t negate the fact that, as Nobel Laureate in Economics James Buchanan describes it, “scarcity introduces the necessity of choice” (1).
It follows from the concepts of scarcity and choice that given a set of alternatives, some things will be chosen, and other things will not be chosen. If you have two hours of free time, you probably can’t go to the movies, AND go to the gym, AND clean the house. The limiting factor of time means that you have to select the activity that you most prefer. This leads to the idea of trade-offs. To acquire the benefits attributed one alternative, the benefits attributed to other alternatives must be foregone. You can’t have it all.
You might prefer different activities for different subjective reasons – you might value going to the movies for the entertainment value, going to the gym for the health benefits, and cleaning the house because you value cleanliness. If you choose going to the movies, you accrue the entertainment value you place on that activity but must forego the benefits you place on exercise and on a clean house. This is the essence of opportunity costs.
Formally, Buchanan defines opportunity costs as follows: “Opportunity cost is 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.” (1)
Opportunity costs force decision makers to enumerate and weigh the costs and benefits associated with pursuing various courses of action, and especially of the costs associated with forgoing the next-best-alternative. They facilitate thinking about trade-offs, an inevitable consequence of decision making. Opportunity costs help individuals and organizations with the natural process of economizing – pursuing an efficient allocation of resources to get the most return with what is available. And most importantly, they embody certain inescapable truths about the world, namely that “there is no such thing as a free lunch”. Stated differently, in the face of scarce resources, individuals must make tough decisions.
The trick to making those tough decisions is leveraging the resources available in a principled way that is aligned with the decision maker’s objectives and strategy.
Collier Research Systems is a trusted partner with the expertise to help guide these types of decisions. To learn more about how we can help you evaluate trade-offs and make the most of your resources, visit www.collierresearchsystems.com.
(1) James M. Buchanan (1991) “Opportunity Cost.” In: J. Eatwell et al. (eds.), The World of Economics, Palgrave Macmillan.