Academic journal article Journal of Forensic Economics

Opportunity Cost vs. Replacement Cost in a Lost Service Analysis

Academic journal article Journal of Forensic Economics

Opportunity Cost vs. Replacement Cost in a Lost Service Analysis

Article excerpt

I. Introduction

Everything for which economists provide valuation uses either an opportunity cost or a replacement cost approach. With an opportunity cost approach, value is based on what an individual sacrificed to obtain a set of goods, services or assets. With a replacement cost approach, value is based on what one would have to pay to replace a set of goods, services and assets. Both of these measures of value are used by different researchers for the valuation of lost nonmarket services in personal injury and wrongful death actions.(1) This paper reviews general issues with respect to the two basic approaches. Sometimes only one approach is even possible, but in a world of perfect information, both approaches would often lead to results that would differ only in terms of tax and job-related fringe benefit difference (for reasons to be discussed in the next section). However, the availability of reliable data creates advantages and disadvantages for each approach, depending on circumstances. The paper also briefly considers differences between the uses of all methods and approaches in wrongful death analysis, compared with personal injury analysis.

Within each approach, there are two basic methods for valuation. The opportunity cost approach includes the simple opportunity cost method and the implied long-term opportunity cost method. The replacement cost approach includes the specific services replacement cost method and the general replacement cost method. Each of these methods is described below. Here again, the availability of reliable information determines which of these methods is most accurate under which circumstances. The "equimarginal error" which often occurs with the replacement cost method is discussed at length.

II. Approaches, Methods and Available Data

Opportunity cost and replacement cost approaches to assessment of economic values are basic to economic analysis, so that all economists utilize both replacement cost approaches and opportunity cost approaches in making valuations. Which approach is used depends on the valuation being made. In forensic economics, any assessment of the value of the lost earnings of a disabled child will use an opportunity cost approach. The child has lost the opportunity to pursue a normal career in the labor market, but it is ordinarily impossible to replace that opportunity at any price. Thus, economists can only use the opportunity cost method for developing a valuation. In contrast, any valuation of a life care plan must be performed with a replacement cost approach. The life care plan itself is set of goods, services and assets needed to come as close to giving the individual the same level of health the individual had before the injury as is possible. That necessitates a number of replacement goods services and assets because the opportunity to fully restore the individual to pre-injury health status does not exist. Ordinarily, nothing could give the injured person the opportunity not to need the life care plan. Thus, the issues involved with whether to use a replacement cost approach or an opportunity cost approach do not depend on a fundamental superiority of one method over the other, but rather the "fit" of each approach to the valuation task at hand. In some circumstances, only the replacement cost approach would work. In others, only the opportunity cost approach would work.

In a lost service analysis, both approaches can be used. An economic expert can try to assess the value of the lost opportunity to perform household services as a method for measuring the lost services or the expert can attempt to assess the cost of replacing the services that were lost by hiring other persons in the labor market to perform those services. The opportunity cost approach values both the time cost and the cost of other resources an individual has sacrificed in producing the services that were lost. A replacement cost approach is based on the cost of replacing the services that an individual had previously provided. …

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