Question

Consider three possible uses of a dam:

(a) produce hydroelectricity
(b) regulate water flows for recreation (rafting below the dam, boating above the dam)
(c) removal of the dam to improve fish passage

Assume that these choices are mutually exclusive and that one of them must be selected. Further, suppose that the choice is made to remove the dam. What is the “opportunity cost” of this decision? List some sunk costs related to this decision. Why shouldn’t they be included as part of opportunity costs?

Answer 1

Opportunity cost is the value of the next best thing you give up whenever you make a decision. It is "the loss of potential gain from other alternatives when one alternative is chosen".

A sunk cost refers to money that has already been spent and which cannot be recovered.

If a dam is already constructed and there are three possible uses of the dam from which one is to be chosen.

(a) produce hydroelectricity
(b) regulate water flows for recreation (rafting below the dam, boating above the dam)
(c) removal of the dam to improve fish passage

Suppose the choice is made to remove the dam.

The opportunity cost of the decision to remove the dam will include all the other possible uses which are left(not chosen). So this includes the revenue or profit which could have been generated from the production and use of hydroelectricity and the revenues which may have been generated from the recreation activities, which includes rafting and boating.

The sunk costs related to this decision will include all the costs which may have been incurred on the construction of the dam including the labour cost, capital and raw materials. This is because now if the decision is taken to remove the dam, the dam must be demolished and hence the cost incurred on its construction can't be recovered and they are permanently lost or sunk. If the hydropower plant is already setup than the sunk cost will also include the cost of constructing the plant.

This will not be included in opportunity cost because an opportunity cost can be recovered if we again change our decision but a sunk cost can't. As if dam is once demolished than if again we want to return to one of the above decisions than we have to again spent money on construction of dam.