1.5: Reality Shot

When measuring the opportunity cost of anything you need to quantify what was given up. Measuring costs in money terms (e.g., dollars, yen, euros, yuan) can be misleading. For example, in 1990 you may have spent $200 a year on shoes. Now, you spend about $400 a year. Just because you are spending more in nominal dollars does not mean you are giving up other goods. If your income doubled since 1990, then you could afford to spend twice as much on shoes and still afford all the other goods and services you consume daily.

A better way to measure opportunity cost is to show how spending on shoes has changed relative to your income. Let’s say spending on shoes represented 2% of your annual income in 1990. Now, your shoe spending now represents 6% of annual income. Without knowing the money value of your spending, we can say that opportunity costs associated with shoes have increased. We can say this because you now have a smaller share of income to buy other goods and services.

We can apply this tactic to measure the opportunity cost to the U.S. associated with military spending. In this case, we will use the value of all economic output (gross domestic product – GDP) to measure the change in the military’s opportunity cost. See figure 1.

Figure 1

You can see that in the 1960’s, the U.S. committed a far larger share of its economic activity to the military. Even though the U.S. currently spends more money on defense, this spending does not represent a higher opportunity cost to Americans.

---