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Revisiting Opportunity Cost

May 3, 2004

In an article in the March 2003 Harvard Business Review entitled 'For the Last Time: Stock Options Are an Expense', authors Zvi Bodie, Robert S. Kaplan, and Robert C. Merton attempt to justify the expensing of stock options. As shown in the excerpt quoted below, one of the keystones of their argument is a claim that because stock grants represent an opportunity cost to the company, both stock and option grants must be expensed, even though current practice is to only expense stock grants.

While I am in agreement that both stock and option grants must be treated the same, I would claim that stock grants themselves should not be expensed. While there are many reasons for this claim, I want to concentrate instead here on the erroneous claim that stock grants represent an opportunity cost. Note that even if stock grants did represent an opportunity cost, it would not necessarily indicate that an accounting expense was appropriate.

"...Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost that needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company's cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors. It is exactly the same with stock options. When a company grants options to employees, it forgoes the opportunity to receive cash from underwriters who could take these same options and sell them in a competitive options market to investors...."

Reduced to the point of interest, this is a claim that a company incurs an opportunity cost equal to the market price for a share of stock granted to an employee.

In analyzing this claim, the first thing to note is what is not said. There are three words missing, i.e. 'Assuming perfect competition.'

In merely claiming an opportunity cost equal to the current market price of the stock granted, there is no qualification being made for the extent of supply and demand and the technical competitive structure of the market for company shares. Without an explicit qualification, there must be an implicit assumption that the company cannot affect the market price of the stock or the opportunity cost by selling shares. If this assumption had been made explicit, it is almost certain that the authors would have realized that it made no sense.

It seems likely that the best model for a company selling its shares is that of a monopoly seller, facing a single price market in which it cannot practice price discrimination.

In such a model, a company serves its self-interest by selling only enough shares, at a sufficiently low and uniform price, so that its marginal revenue is driven down to its marginal cost. Note that 'marginal revenue' means the increment in total revenue due to a marginal unit sold, not the price of the marginal unit. In the case of zero marginal cost, the price is set to maximize the total revenue received, and the quantity is that which the market demands at that price. If the marginal cost is not zero, this simply means that the restriction of shares sold is tighter, the price is higher and the quantity sold is less.

In any case, the opportunity cost for refraining from selling a marginal share must be equal to the benefit that would have been otherwise received. But all of the possible benefits have already been extracted and further sales will leave the company worse off. Thus there can be no question of a positive opportunity cost.

In fact, an alternate description of a monopoly supplier would be one that restricts its supply up to the point where it starts to incur a positive opportunity cost for doing so.

If a cartel of Brazilian coffee growers decide to burn 25% of their crop, they are attempting to maximize their profits by preventing oversupply and low prices that fail to yield enough incremental demand, and they do not suffer an opportunity cost for doing so.

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