Trade-offs and opportunity cost
Why every choice gives something up, and how to count the real cost of a decision.
FinanceEveryday economicsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain scarcity and why it forces trade-offs
- Work out the opportunity cost of a choice, including time
- Describe the trade-off between efficiency and equality
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 1 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 1
What it is
Scarcity means a society has less than people would like of time, money, land, workers and machines. Economics is the study of how a society manages its scarce resources.
Because resources are scarce, every choice is a trade-off: to get more of one thing, you give up some of another. Mankiw's first principle is that people face trade-offs. An hour spent on one subject is an hour not spent on another, or working, or resting.
Societies face trade-offs too:
- Guns and butter: more spending on defence leaves less for consumer goods.
- A clean environment and income: pollution rules bring cleaner air, but raise firms' costs, which falls on owners, workers and customers.
- Efficiency and equality: efficiency is the size of the economic pie; equality is how evenly it is divided. Policies that share income more evenly, such as income taxes and welfare payments, can reduce the reward for working hard, so the pie may get smaller.
Mankiw's second principle follows: the cost of something is what you give up to get it. This is its opportunity cost.
Quick check
Tap an answer to check it.
You spend an evening at a concert instead of working a shift that pays 60. The ticket costs 40. What is the opportunity cost of the evening?
- That leaves out the wages you gave up
- That leaves out the ticket price
Show answer
100: the ticket plus the 60 you would have earned. Opportunity cost counts everything you give up: money spent and income forgone.
Why it matters
Costs are often not what they first seem. Mankiw's example is going to college:
- Adding up tuition, books, room and board overcounts in one way: you would need somewhere to live and food to eat anyway, so room and board are a cost only where they cost more than living elsewhere.
- It undercounts in another: it ignores your time. For most students the earnings given up while studying are the largest single cost of their education.
This explains choices that look odd at first. Young athletes who could earn very large sums by turning professional face a very high opportunity cost of staying in college, so it is not surprising that many leave.
Knowing that trade-offs exist does not say which choice is right. It makes sure the choice is made with the real costs in view.
Worked example
A student is deciding whether to spend a year on a full-time course. Figures are made up.
| Item | Amount |
|---|---|
| Tuition and books | 9,000 |
| Rent and food during the year | 8,000 |
| Rent and food if not studying | 8,000 |
| Wages given up (a full-time job) | 18,000 |
- Rent and food cost the same either way, so they are not a cost of the course.
- Opportunity cost = tuition and books + wages given up = 9,000 + 18,000 = 27,000.
The simple "money spent" total (9,000 + 8,000 = 17,000) is wrong twice: it includes living costs that don't depend on the choice and leaves out the largest cost, the wages.
Common mistake
Counting only money paid out. Time has a cost because of what you could have done with it; and costs that you would pay whichever way you choose are not costs of the choice.
Key terms
- scarcity
- the limited nature of a society's resources
- economics
- the study of how a society manages its scarce resources
- trade-off
- giving up some of one thing to get more of another
- opportunity cost
- whatever must be given up to obtain something
- efficiency
- getting the most from scarce resources (the size of the pie)
- equality
- sharing the benefits evenly (how the pie is divided)
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| scarcity | the limited nature of a society's resources |
| economics | the study of how a society manages its scarce resources |
| trade-off | giving up some of one thing to get more of another |
| opportunity cost | whatever must be given up to obtain something |
| efficiency | getting the most from scarce resources (the size of the pie) |
| equality | sharing the benefits evenly (how the pie is divided) |
Practice
Work it through
A course costs 4,000 in fees. While on it you give up a part-time job paying 6,000. You would pay 5,000 in rent either way.
- Paid only because you take the course
- Income you lose by choosing the course
- 4,000 + 6,000; the rent is paid either way
Quick quiz
Tap an answer to check it.
Why does Mankiw say room and board are not really a cost of going to college?
- Who pays does not change whether it is a cost of the choice
- They can be large; the point is that they don't depend on the choice
Show answer
You would need somewhere to live and something to eat even if you didn't go. Only costs that change with the decision belong in its opportunity cost.
What does the trade-off between efficiency and equality mean?
- The two goals often conflict
- Equality here is about how benefits are shared
Show answer
Policies that share the pie more evenly can make the pie smaller. Efficiency is the size of the pie; equality is how it is divided.
Sort it
Which group does this belong to?
Wages given up while studying
Income you lose by choosing to studyShow answer
Part of the opportunity cost. Income you lose by choosing to study
Tuition fees
Paid only because of the choiceShow answer
Part of the opportunity cost. Paid only because of the choice
Food you would eat anyway
You pay it whichever way you chooseShow answer
Not part of it. You pay it whichever way you choose
A gym membership you keep either way
It does not depend on the choiceShow answer
Not part of it. It does not depend on the choice
In short
- Scarcity forces trade-offs, for people and for societies.
- Society's trade-offs include guns and butter, the environment and income, efficiency and equality.
- Opportunity cost is what you give up, including time and income forgone.
- Costs you would pay either way are not costs of the choice.
Mastery check
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Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What is the opportunity cost of something?
Show answer
Whatever must be given up to obtain it.
For most students, what is the largest single cost of education, according to Mankiw?
Show answer
The earnings given up while studying.
In the efficiency–equality trade-off, what does efficiency describe?
Show answer
The size of the economic pie: getting the most from scarce resources.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 1.
- On this site: Thinking at the margin and incentives.
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