AboutWarren D. Miller, CFA, ASA, CMA, CPA Expertise My in-depth knowledge of economics is confined to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Other questions dealing with macroeconomics, the traditional neoclassical paradigm, labor economics, environmental economics, agricultural economics, health economics, and so on should go to those who have the appropriate expertise.
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Experience I work with Austrian economics (which is different in major respects from the traditional neoclassical model), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) everyday in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and clients to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.
Organizations CFA Institute, Strategic Management Society, American Society of Appraisers, Institute of Management Accountants, Academy of Management, Culver Legion
Publications CFA Magazine, Strategic Finance, Valuation Strategies, Value Examiner, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, and Business Valuation Review, among others
Education/Credentials MBA - Oklahoma State (1991)
BBA - U. of Oklahoma (1975)
Chartered Financial Analyst designation (2006)
Accredited Senior Appraiser (2006)
Certified Management Accountant (1992)
Certified Public Accountant (1992)
Question Hello Sir,
I have a question about interest rates. In my text book its stated that Interest rate is actually the opportunity cost of Quantity of money demanded (cash we use to purchase goods or can say cash on hand we kept in our pockets). By keeping the money to ourselves we are giving up the amount we could earn (interest)in bank account. Thus the interest rate is the opportunity cost of quantity of money demanded. Its a bit twist and turn but somehow i understand this point. Now I want to ask: Could we put this inversely like "Quantity of money is the opportunity cost of interest rate"?
I read that opportunity cost has both sides (Production frontier) and its doubting my understanding.
Take care Sir!
Answer Hi, Sonia--
Thank you for a most interesting question. You have a great mind to think of a question like that. I can help you.
First, let me try to help you understand the concept of "opportunity cost." At its base, microeconomics is the study of choice. It is almost always about choice in one form or another. The opportunity cost of one choice is the cost of the closest alternative that was not chosen. Let me give you an example and a couple of internet links that will expand on what I say.
Let's say that you have the choice of being tutored studying for four hours by someone who charges you $15/hr. or working part-time for @ $10/hour. If you choose to be tutored, for which you are not paid anything (at least while you're studying, but you might get a big payoff later in your life from what you learned!), then the opportunity cost of your choosing to study is the $40 you could have earned by working part-time instead. If you choose to work part-time, the cost of working is the value of the knowledge you could have acquired by studying. That value is hard to measure, of course, but it is still the opportunity cost.
Now, as you can see from that second link, we are ready to talk about the "production possibility frontier" (not the "production frontier). The production possibility frontier is called the PPF, for short. The PPF is more of a macroeconomic concept - that is, it occurs at the "country" or "nation" level. The choices a country makes do have opportunity costs associated with them, as the article itself explains.
In the specific question you ask, I would not say, "The quantity of money is the opportunity cost of the interest rate." I would say, for example, that "holding money in the expectation that interest rates are going to increase is the opportunity cost of not earning interest now." Conversely, "the opportunity cost of earning interest now is the value of what I could have done with the money [e.g., invested in stocks, bought an HD TV, holding the money in hopes of finding a bargain on something I wanted to buy, etc.]. Opportunity cost does fall along the PPF, though. That is true.
In summary, I think it's fair to say that opportunity cost is a two-edged sword, as you rightly recognize. However, when there is not a specific measure of the next-best choice, describing the cost of NOT making that choice can be quite difficult, as I hope you understand now.
Please do me a favor and fill out the 'rate-the-expert' email you'll receive right after you get this reply. Your ratings and comments help me do a better job of helping folks like you who ask such interesting questions!
