Opportunity Cost, We Begin by Discussing What Opportunity Cost Is

Department of Managerial Economics and Decision Sciences 1 NOTE ON ECONOMIC PROFIT In judging the success of a business enterprise, one almost always starts with the question: “How profitable is the business and is it likely to remain profitable over time?” The purpose of this note is discuss the concept of economic profit and to illustrate how it relates to and differs from more conventional notions of accouting profit. Because the concept of economic profit is grounded in the concept of opportunity cost, we begin by discussing what opportunity cost is. We then turn our attention to economic profit. Finally, we show how economic profit is related to the concept of net present value that you are learning (or have learned) in Finance. OPPORTUNITY COST Decision making in business is about choosing among alternative courses of action. Consider a decision maker who has to choose from a set of mutually exclusive alternatives, each of which entails a particular monetary payoff. The opportunity cost of a particular alternative is the payoff associated with the best of the alternatives that are not chosen. To understand the concept of opportunity cost more concretely, consider two examples: You own and manage your own business. The business requires an average of 80 hours of your time every week. Suppose instead of working in your own business, your best alternative is to work the same amount of hours in a large corporation for an income of $75,000 per year. The opportunity cost of the time you devote to your business would therefore be $75,000. An automobile firm has an inventory of sheet steel that it purchased for $1,000,000. It is planning to use the sheet steel to manufacture 2,000 automobiles. As an alternative, it can resell the steel to other firms. Suppose that the price of sheet steel has gone up since the firm made its 1This note was written by Professors David Besanko. Parts of this note were adapted from “Economics Primer,” Besanko, D., D. Dranove, and M. Shanley, Economics of Strategy (New York: John Wiley & Sons), 2000, while others were adapted from “Notes on Cost,” by Professor Nabil Al-Najjar. This note is for the use exclusive us of students in MECN 430 at the Kellogg School of Management. Do not circulate or copy this notes for any other use without explicit permission. Version of November 10, 2003. purchase, so if it resells its steel the firm would get $1,200,000. The opportunity cost of using the steel to produce the 2,000 automobiles is thus $1,200,000, or $600 per automobile. Note the opportunity cost differs from the original expense incurred by the firm. After reading this last example, students sometimes ask, “Why isn’t the opportunity cost of the steel $200,000: the difference between the market value of the steel ($1,200,000) and its original cost ($1,000,000)?” After all, the firm has already spent $1,000,000 to buy the steel. Why isn’t the opportunity cost the amount above and beyond that original cost ($200,000 in this example)? The way to answer this question is to remember that the notion of opportunity cost is forward looking, not backward looking. That is, opportunity cost measures what the decision maker sacrifices at the time the decision is made and beyond. When the automobile company uses the steel to produce cars, it gives up more than just $200,000. It forecloses the opportunity to receive a payment of $1,200,000 from reselling the steel. The opportunity cost of $1,200,000 measures the full amount the firm sacrifices at the moment it makes the decision to use the steel to produce cars rather than to resell it in the open market. Opportunity Costs Depend on the Decision Being Made The forward-looking nature of opportunity costs implies that opportunity costs can change as time passes and circumstances change. To illustrate this point, let’s return to our example of the automobile firm that purchased $1,000,000 worth of sheet steel. When the firm first confronted the decision to “buy the steel” or “don’t buy the steel,” the relevant opportunity cost was the purchase price of $1,000,000. This is because the firm would save $1,000,000 if it did not buy the steel. But --- moving ahead in time --- once the firm purchases the steel and the market price of steel changes, the firm faces a different decision: “use the steel to produce cars” or “resell it in the open market.” The opportunity cost of using the steel is the $1,200,000 payment that the firm sacrifices by not selling the steel in the open market. Same steel, same firm, but different opportunity cost! The opportunity costs differ because there are different opportunity costs for different decisions under different circumstances. Opportunity Costs and Market Prices Note that the unifying feature of this example is that the relevant opportunity cost was, in both cases, the current market price of the sheet steel. This is no coincidence. From the firm’s perspective, the opportunity cost of using the productive services of an input is the current market price of the input. The opportunity cost of using the services of an input is what the firm’s owners would save or gain by not using those services. A firm can “not use” the services of an input in two ways. It can refrain from buying those services in the first place, in which case the firm saves an amount equal to the market price of the input. Or it 2 can resell unused services of the input in the open market, in which case it gains an amount equal to the market price of the input. In both cases, the opportunity cost of the input services is the current market price of those services. 2 EXAMPLE: Asset Plays Sometimes there is a large discrepancy between the accounting value and the economic value of a firm's assets. For example, an unsuccessful retailer might have stores in downtown Chicago with land valued at historical cost from the time the buildings were bought in the 1950s. As a takeover candidate, the company might look unattractive in terms of its margins or the book value of its assets. But, the book value does not reflect the stores' higher real estate values; an investor could buy the firm and sell off its assets at market prices. Here, the correct tool for evaluation is the opportunity cost of the resources - not the book value of the company. Such opportunities are called “asset plays.” The idea is to identify companies whose book value does not reflect the true economic value (opportunity cost) of the underlying assets. Investment in such “asset plays” will be profitable when the market has, for some reason, failed to account for the true opportunity value of the firm's assets employed in their optimal use. Thus, even poorly managed companies should be priced at close to their true market value. Otherwise, there exists a profitable takeover candidate, either by realizing the liquidation value or recognizing how existing assets can be better managed so as to achieve their true opportunity value. ECONOMIC COST AND ECONOMIC PROFIT The concepts of economic cost and economic profit are based on applying the concept of opportunity cost to the firm as a whole. The economic cost incurred by a business firm over a given period (say, a year) is the sum total of all of its costs, including any relevant opportunity costs incurred over that period of time.3 The firm’s economic profit over a given period of time (again, say, a year) is the difference between the firm’s total revenue over that period and its economic cost. To illustrate, consider a small software development firm that is owner operated. In 2004, the firm earned revenue of $1,000,000 and incurred expenses on supplies and hired labor of $850,000. The owner’s best outside employment opportunity would be to earn a salary of $200,000 working for Microsoft. The software firm’s accounting cost is $850,000, and its accounting profit is thus $1,000,000 - $850,000 = $150,000. The software firm’s economic cost is its accounting cost plus the opportunity cost of the owner’s labor services: $850,000 + $200,000 = $1,050,000. Its economic profit is thus: $1,000,000 - $850,000 - $200,000 = -$50,000. This negative economic profit (or economic loss) 2 See Peter Lynch: One Up On Wall Street, Penguin Books, 1989, for examples of asset plays that helped him make a fortune for Magellan Fund shareholders. 3 Thus, when we talk about total cost curves in microeconomics, we typically mean total economic cost. 3 means that the owner made $50,000 less in income by operating this business than she could have made in her best outside alternative. The software business “destroyed” $50,000 of the owner’s wealth in that, by operating the software business, she earned $50,000 less income than she might have otherwise. Economic Profit in Firms With Long-Lived Assets Economic profit becomes a more subtle when dealing with firms that have long-lived assets, such as plant, equipment, and land (which, of course, is most business firms!). Nevertheless, the concept is still firmly rooted in the notion of opportunity cost. To illustrate, consider the following sequence of examples: Example #1: You are considering starting a hot dog stand. The hot dog stand will generate a revenue of $100,000 a year.

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