The road not travelled

Opportunity cost in evaluation

Why does value for money matter? Like, why is it even a thing?

One important reason is that resources are finite. While ideas might flow endlessly, our capacity to bring them to fruition is constrained by practical limitations. Time, money, expertise, energy, and natural resources are all scarce, creating bottlenecks between inspiration and implementation. Consequently we have to make choices about which needs and wants to fulfil, and how best to fulfil them.

Each time we decide to do something, we’re also deciding not to do something else - and we miss out on the potential value we could have gained from that next-best thing. Economists refer to this foregone value as opportunity cost.

The idea of opportunity cost is well captured in Robert Frost’s famous poem, The Road Not Taken (1915):

Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I-
I took the one less traveled by,
And that has made all the difference.

The poem’s concluding lines about taking “the road less traveled” are often seen as a celebration of individualism and non-conformity. However, in this post, Alia Parker explains that Frost’s poem expresses lament for “what’s not there, the things we don’t experience through the inevitability of choice”. Frost regretted not being able to explore both roads, foregoing the benefits of the unchosen path. He had to make a decision with limited information. Once chosen, it was unlikely that he would return to try the other path. The “sigh” in hindsight reflects the wistfulness of imagining what might have been - the essence of opportunity cost. Just for fun, check out Parker’s translation of the poem into Australian (That other bloody road).

The need to choose between options often entails trade-offs; for example, perhaps one road had significant travel time benefits while the other had scenic beauty. Both were good, in different ways - yet a choice had to be made. The poem also hints at a connection between opportunity cost and path dependence - “how way leads on to way” - sometimes, historical decisions constrain future options, locking us into a path if changing direction is too costly or impractical.¹

More formally:

Opportunity cost is the value foregone by not implementing the next-best alternative use of resources - including any monetary and non-monetary costs and benefits associated with the decision.

Algebraically:

Opportunity cost = FO - CO

Where:

FO = return on foregone option

CO = return on chosen option.

For example:

• If you decide to spend money on a new car instead of investing it in the sharemarket, the opportunity cost in financial terms is the difference between the dividends and capital growth you could have made on the foregone share portfolio, and the future value of the car. The gap between these particular two paths (the opportunity cost) widens over time as the return on investment increases and the value of the car decreases - making the car more costly than it may initially appear. Ultimately, you may find you’ve sacrificed years’ worth of retirement savings for scrap metal! Of course, your real-world decision is likely to reflect non-financial aspects too, such as the utility you derive from car ownership (e.g., convenience, necessity for work, etc), personal preferences and other factors.

• If you decide to attend tertiary education or vocational training, the financial opportunity cost of the decision includes both the enrolment fees you pay and the income you could have earned if you’d instead got a job. In this case, the opportunity cost changes direction over time. Initially, further education makes you financially worse off than taking paid work, but over the longer term, one hopes, it will lead to better-paying work that makes the short-term sacrifice worthwhile. This example illustrates the importance of considering different time horizons when evaluating opportunity costs. There are also intangible opportunity costs to weigh up in this decision; which of these two alternative lives do you prefer to live?

• If a decision-maker needs to approve the construction of several new hospitals to keep up with demographic changes and increasing demand for health care services, but only has immediate resources to build one hospital, they need to decide which hospital to build first, bearing in mind the costs and consequences of each alternative. An interesting twist on this decision, building two “good” hospitals serving a wider geographic area and a larger population may turn out to be more valuable than building one “excellent” hospital - illustrating the principle of diminishing marginal returns, where additional investments in making a single hospital better and better may yield progressively smaller benefits. Could taking opportunity cost into account sometimes lead us to conclude that “good enough” is better value than “perfect”? (Thanks to a VfI workshop participant for this insight).

Use of opportunity cost in economic methods of evaluation

The practical implication of opportunity cost is that when we’re evaluating a policy or program, it’s desirable to be clear about what its next-best alternatives are, and to understand their respective resource requirements and value propositions. If we don’t, we may conclude that a program is “good” but we’ll never know if an alternative might have been better.

Economic methods of evaluation encourage this clarity inherently within their structure. For example:

• Costs included in economic analysis are not only direct financial expenditures but also include estimates of the opportunity costs of intangible resources invested, such as volunteer time and resources donated in-kind;

• A cost-effectiveness analysis (CEA) directly compares an intervention with its next-best alternative, based on the costs of achieving a gain in an outcome or utility measure that the interventions have in common, and expresses the difference between the interventions in an incremental cost-effectiveness ratio;

• A cost-benefit analysis (CBA) may compare and rank two or more interventions based on their net present values (NPV) or benefit-cost ratios (BCR);²

• A standalone CBA of one intervention also performs the neat trick of comparing the intervention with a hypothetical universe of next-best alternatives, by setting the discount rate at the expected rate of return from similar investments. This is a topic for another post.

These methods bring disciplined approaches to considering alternative courses of action and their potential value. Economic modelling is also useful to explore the dynamics of opportunity costs:

• Under different sets of of assumptions (e.g., optimistic, realistic, and pessimistic);

• From different perspectives (e.g., government payer vs. whole-of-society); and

• For different groups (i.e., distributional effects).

Modelling can also reveal how opportunity costs may evolve over time due to variations in the timing of costs and benefits of alternatives, technological advances, market changes, and shifting societal needs and preferences.

Economic methods of evaluation don’t exist in isolation from other methods. To help canvass the full range of alternative options and intangible values, analysts can supplement economic methods with other methods such as stakeholder consultations, interdisciplinary panels, or literature reviews.

Use of opportunity cost in evaluation more generally

Evaluators can make judgements about opportunity cost with or without conducting a full economic evaluation, by systematically considering the resource requirements, impacts, and trade-offs of alternatives.

To do this, the first step is to identify alternatives to the policy or program being evaluated. The next step is to identify the basis upon which they should be compared, such as their impacts, costs and any other relevant factors. These factors could be defined in terms of criteria (aspects of performance) and standards (levels of performance), providing an explicit framework (such as a rubric) for making systematic, transparent comparisons between alternative courses of action.

The different options can then be compared, quantitatively and/or quantitatively, to identify trade-offs and assist in clarifying the preferred option or options.

Here’s an example of a rubric developed for this purpose.

Source: FSD Africa. (2018). VfM Framework. Prepared by Oxford Policy Management Ltd and Julian King & Associates Ltd.

Strengths and limitations

Understanding opportunity cost helps people and organisations make more informed choices, evaluating trade-offs between alternatives and allocating limited resources in ways that can maximise value. Taking opportunity cost into account can lead to better long-term social, financial and personal decisions.

While opportunity cost is an important and useful concept, applying it isn’t always straightforward. It can be challenging to accurately identify all potential alternatives and quantify their costs and consequences. Decision-makers may not always have full information about all available options. Nonetheless, being explicit about what we know (and don’t know) about alternative courses of action can help to inform sound resource allocation decisions.

Image purchased from Shutterstock

The policy not funded

Two proposals diverged in a constrained budget,
And, sorry I could not choose them both,
As decision-maker, I couldn’t fudge it,
I weighed one path; I had to judge it,
On its costs, benefits and their discounted growth.

Then chose the other, just as sound,
And perhaps with the stronger claim,
For its promise lay in fertile ground;
Though in truth, as I looked around,
Their potential seemed about the same.

And both that morning equally lay,
Untested, their impacts yet to unfold.
Oh, I left the first for another day!
But knowing one choice shapes the way,
Its merits would remain unsold.

I shall recall this with a sigh,
Unrealised value, forever lost:
Two policies diverged, and I,
I chose the one less tried nearby,
Based on opportunity cost.

1. However, not all decisions are path-dependent. Sometimes changing paths is desirable. In these cases we need to avoid the sunk cost fallacy. Sunk costs are expenses or investments already incurred that can’t be recovered. Economists argue that sunk costs don’t affect future events or choices and should therefore be ignored when making decisions about the future. For example, in my undergrad years when deciding to switch from architecture to science, the time I’d already invested in the preliminary, qualifying year for architecture didn’t figure in my decision. What mattered was the future pros and cons of the two alternative paths. The sunk cost fallacy is a bias that can lead us to keep investing in something simply because we’ve already committed resources, even when it’s no longer rational to do so. Getting good value for money includes knowing when to change paths.

2. Choice of indicator (BCR or NPV) is important when ranking projects because different indicators can lead to different rankings. Mutually exclusive alternatives (same project, different options) should be compared on the basis of NPV, selecting the option with the greatest NPV that fits within the allocated budged. When comparing projects of different sizes, NPV is generally preferred. On the other hand, unrelated projects to be funded from a limited budget should be ranked on the basis of BCR, where the BCR’s denominator only includes costs drawn from the limited pool of funds being allocated.