Climate Change 2001: Working Group II: Impacts, Adaptation and Vulnerability

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2.5.1. Elements of Costing and Valuation Methods

2.5.1.1. Opportunity Cost and the Foundations of Valuation Methods

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 (reasonably) secure.
• 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.