Choice and Opportunity Costs

Abstract

We define the (physical) opportunity cost of a choicexas the alternative that would be chosen ifxwere not available, and the opportunity cost of any unchosen alternative asxitself. The agent has preferences over pairs consisting of alternatives and their opportunity costs. Because costs affect choice and vice-versa, choice results from an intrapersonalequilibriumrather than from simple maximisation. In spite of significant rationality assumptions, the resulting behaviour can be highly non-standard, allowing intransitive choices. Rational utility maximisation is ensured by an additional new consistency condition on preferences. However, we argue that the maximised utility cannot be straightforwardly interpreted as a welfare relevant “revealed preference”. A generalisation of our model accommodates additional departures from standard rationality in the form of menu effects.