2.5.1. Elements of Costing and Valuation Methods
18.104.22.168. Opportunity Cost and the Foundations of Valuation
Opportunity cost is the fundamental building block of modern economic analysis.
The true economic cost of one unit of some good X reflects the cost of opportunities
foregone by devoting resources to its production. This cost measures the economic
value of outputs, goods, and services that would have been possible to produce
elsewhere with the resources used to produce the last unit of good X. The social
opportunity cost of employing a resource for which there is no alternative economic
use is thus zero, even if its price is positive, and opportunity cost will be
different under conditions of full employment than under circumstances involving
large quantities of visible or invisible unemployment. Moreover, opportunity
cost applies only to small "marginal" changes from equilibrium in
systems for which there are multiple equilibria. Likewise, the marginal benefit
from consuming good X is the value of the last unit purchased, measured in terms
of a real price that reflects the welfare that would have been enjoyed if the
requisite expenditure had been devoted to consuming another good (or goods).
These concepts may appear circular, but that is an artifact of the circular
nature of economic systems. Suppliers of some economic goods are consumers of
others. The opportunity cost of a good to the producer and the marginal benefit
to the consumer are equal when all of the following conditions are obtained:
- All markets are perfectly competitive.
- Markets are comprehensively established in the sense that all current and
future property rights are assigned.
- Marketed goods are exclusive (ownership is singular and well defined) and
transferable (goods can be bought, sold, or given away).
- The underlying social and legal systems guarantee that property rights are
- There are no transaction costs involved in creating and/or maintaining any
current or future market.
- There is perfect and complete information about all current and future markets.
Under these conditions, the marginal opportunity cost of any good with multiple
uses or multiple demanders is equal to its marginal benefit. Marginal (opportunity)
cost and marginal benefit then match the accounting price that can be read from
the market, and economic efficiency is assured in the sense that nobody can
be made better off without hurting somebody.
It is not difficult, of course, to think of circumstances in which one or more
of these conditions do not hold (and this is not news to the economics profession).
Much of modern economics has been devoted to exploring how to measure and compare
costs and benefits when these conditions break down. For researchers interested
in impacts, however, theoretical results are less important than some practical
insight into what to do.
Theory instructs, for example, that producers who have some monopoly power
in imperfectly competitive markets would restrict output compared to the quantity
that would prevail in a competitive market. Consequently, marginal opportunity
cost would fall short of marginal benefit even if all of the other assumptions
held, and the market price would overestimate marginal cost by an amount that
is related to the price elasticity of demand.