Optimal decision-making and opportunity costs | AP(R) Microeconomics | Khan Academy

What we're going to do in this video is think about optimal decision making by rational agents. It’s just thinking about how would a logical someone with a lot of reasoning ability make optimal decisions and make the best decisions for themselves. Well, they would look at the costs and benefits of a decision, and they would try to do the action that maximizes the difference between benefits and costs. So, they would want to maximize benefits—benefits minus costs.

This is an important idea because I think all of us would like to be rational agents, logical agents, making optimal decisions. Now, when we think about benefits and costs, benefits you might try to quantify it somehow, maybe in terms of dollars. What’s the benefit of, say, going to a movie or having some ice cream? Costs we tend to associate with the price. The cost of going to a movie, say, might be ten dollars. Those types of things are known as explicit costs when there’s an explicit price associated with it.

But there’s also something known as implicit costs, and the most well-defined implicit cost is the idea of an opportunity cost. The opportunity cost, in economic terms, is defined as the cost of the next best alternative. So, if I'm going to go to a movie, there might be the explicit cost of paying for the movie, but then there’s the implicit costs. Maybe if I'm going to a movie, that time I could have used for something else. Maybe I could have earned money somehow.

A rational actor would consider both of those and then compare them to the benefit of going to the movie. If that’s what maximizes the difference between benefits and costs, well, they might decide to do that. Now, to make this a little bit more tangible, let’s look at that exact example.

Suppose you have the choice between going to a movie for three hours versus working for three hours. Movie tickets cost ten dollars. If you work, you can earn thirty dollars an hour mowing lawns, twelve dollars an hour working in an ice cream shop, or ten dollars an hour weeding your aunt's garden. What is the opportunity cost of going to a movie for three hours, and what is the total cost? So, pause this video and see if you can figure that out.

All right, well, we just have to go back to the definition. The opportunity cost is the cost of the next best alternative. So, what is the next best alternative to going to the movie? Well, I can make the most money if I am mowing lawns. If I am mowing lawns, my opportunity cost is going to be thirty dollars an hour. If I'm going to a movie, that would have been three hours that I would not have been able to mow lawns.

So, my opportunity cost (I'll write OC, I'm not talking about Orange County) right over here is going to be dollars an hour times three hours. So, thirty times three, which is going to be a ninety-dollar opportunity cost. Now, some of you might be saying, "Well, what about the twelve dollars an hour for an ice cream shop or ten dollars an hour for weeding your aunt's garden?" Well, those weren’t the next best alternative. The next best alternative was mowing the lawn.

Some people might be confused and say, "Okay, I'm going to add all of these together per hour and multiply by three," but you’re not going to be able to do all three of these things; you’re going to have to pick one of them. We’re assuming that maybe there aren’t any extra costs that are not—you know, maybe you get extra tired from mowing lawns versus working in an ice cream shop—but we're trying to simplify things, so let's not get overly complicated right now.

So, at a very face level or at a high level, the next best alternative is making thirty dollars an hour mowing lawns. So that would be the opportunity cost. Now, what would be the total cost? Well, the total cost would be the sum of the implicit cost (which is opportunity cost, an example of that) plus the explicit cost.

The implicit cost we already talked about; that is ninety dollars—that's the cost of not this, the opportunity cost of not mowing lawns. Then to that, you’re going to add the explicit cost of just the price of the movie ticket for ten dollars. You get to watch a movie for three hours, so there’s a ten-dollar explicit cost.

So, the total cost of going to the movie is one hundred dollars. How would an optimal decision, or how would a rational agent, use this information to make an optimal decision? Well, they would want to compare that to the benefit of going to a movie. If they could quantify that benefit somehow and say, “Oh yeah, the benefit to me of going to a movie is two hundred dollars,” then that difference between two hundred and one hundred—that's the best difference that I can get out of all of my choices between my benefits and my costs.

Well then, I’m going to go to that movie. So, I will leave you there, and in future videos, we’ll dig a little bit deeper into this.