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Deciding to Invest in Something? Bear in Mind the Opportunity Cost

by Brian Viard

September 23, 2014

Gambling-on-the-dollars

By using the principle of opportunity cost and understanding exactly what value they are getting, companies can make smarter investment decisions.

The old saying claims that, “A bird in the hand is worth two in the bush.” As more Chinese firms purchase assets overseas they may want to keep in mind that this is not always good advice. When deciding whether to own anything, economists recommend an idea which is a little less catchy but that could save firms a lot of money–the idea of opportunity cost.

The opportunity cost of an asset is what you give up by owning it. What you give up is the highest price that anyone else would pay for it. Sometimes this is fairly straightforward. Suppose you own a Volkswagen Jetta sedan. What is your opportunity cost for it? The most you could get for it if you were to sell it to someone else. Let’s suppose this is RMB 68,000.

How should this information affect your decision making? You should keep the car if you value it at more than RMB 68,000 and sell it otherwise. The same logic applies if you do not currently own a used Volkswagen Jetta but are thinking about buying one. You should do so if you will value it at more than RMB 68,000. Otherwise you should not.

In some cases opportunity cost can change rapidly. Suppose you own a 1 kg bar of gold. The opportunity cost of the bar changes every day (actually even more frequently but most people would not monitor it so closely) as the price of gold changes.

Let’s make things even harder. Suppose you manufacture furniture and also own a wood-processing facility to make unfinished lumber. When you use a piece of unfinished wood to make a chair what price do you pay for it? A common response is zero because you do not have to pay anyone for it. However, the price is the opportunity cost and this is not zero. It equals what others would have paid you for it. To make this concrete, let’s suppose that a similar piece of wood costs RMB 50 in the market. In that case, the implicit price of the wood you used is RMB 50.

How is this information useful? Suppose it cost you RMB 55 to produce the piece of wood. Then you should shut down your processing facility and buy wood in the market. In fact, since others must be producing wood below RMB 50, you should sell your wood-processing facilities to one of them because it will be more valuable to them than to you (unless no one can make it cost-effective in which case it should be shuttered).

Although dealing with complex decisions, some Chinese companies considering overseas acquisitions would do well to apply this simple principle. In 2011 Li Xinchuang, Deputy Secretary-General of China Iron & Steel Association recommended: “China currently owns less than 10% of imported iron ore. We should seek 50% of ore from Chinese-invested overseas resources in the next five to 10 years.” Applying the logic of opportunity cost makes me wary of such a blanket approach. A Chinese company (or any company for that matter) should only purchase an iron ore mine overseas (or anywhere for that matter) if it can add more value to the mine than the current owner. We would not expect the current owner to sell the mine for less than its value and if the Chinese company cannot increase the mine’s value then they will certainly overpay.

The motivation behind Li’s advice appears to be to lower the negotiating power of foreign suppliers such as Rio Tinto and BHP. Let’s suppose that these companies have substantial negotiating power (I am not certain this is the case). The idea of opportunity cost still implies that acquisitions should be approached with caution. If Rio Tinto has pricing power because of its size, then this increases the value of its ownership. Rio Tinto would only be willing to sell the mine if it can obtain a price that includes the value of this pricing power. On the other side, the acquirer should only be willing to pay more than this if they can acquire even greater pricing power. This is unlikely given that they will have a lower market share than Rio Tinto. Put differently, Rio Tinto’s opportunity cost is well below its value.

Ignoring opportunity costs may explain some of the pain encountered in previous mining acquisitions. In 2006 Citic Pacific purchased the Pilbara mine in Australia from Clive Palmer’s Mineralogy for $415 million. The project was ultimately $6 billion over budget and finally finished in 2013–four years behind schedule. Sinosteel’s Weld Range project, acquired in 2008 in its acquisition of Midwest Corp., has been suspended since 2011 due to long delays and huge cost overruns in developing transport for the ore. While these losses may be due to bad luck, the magnitude of them makes one wonder if the acquirers considered how their expertise in running mines compared with the previous owners.

Of course, in purchasing a mine the acquirer is placing a bet on future prices of iron ore because mines can last for decades. This means that some acquisition decisions are predicated on better future prices. The idea of opportunity cost again suggests caution. If the acquirer has reason to believe that it can better forecast future iron ore prices than the current owner and its forecasts exceed the current owner’s then this is a compelling reason to buy. However, there should be good reason for the acquirer to believe that its forecasts are better not just higher.

By keeping the idea of opportunity cost in mind and having a clear idea of where value will be added, Chinese firms going abroad can increase their odds of avoiding some of the previously costly endeavors.

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