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October 23, 2006

Oil, Nuclear Power, and Iran:
A Lesson in Opportunity Cost

David R. Henderson

Imagine that you have an oil well that contains enough oil to supply annually three times the amount you would ever want to use in a year. Suppose that one of your main current uses of oil is to generate electric power for your ranch. Would you want to buy electric power from someone else, power that is generated by burning some other fuel, or, possibly, made by a nuclear reactor?

It's a trick question. You can't answer it without comparing two crucial numbers: the cost of the oil you use to generate power and the price you would pay for the alternate form of electricity. If, for example, the cost to you of generating your own power were 7 cents per kilowatt hour (kWh) and the cost to you of buying electric power were 9 cents per kWh, then, all other things equal, you would want to make your own. If, on the other hand, these numbers were reversed, then, all other things equal, you would want to buy your electric power.

But why not use your own? Why buy it from someone else? The answer is: opportunity cost. The opportunity cost of the oil you use is the value of the highest-valued alternate use of the oil. Even though you could use the oil yourself, you also could choose to sell it. And if you could get a high enough price for it, then it might well be cheaper for you to sell the oil and buy electric power made from some other fuel.

Many people, when they hear the term "opportunity cost," think of a concept that they learned in an economics class years ago but didn't think mattered much. In fact, "opportunity cost" is a powerful concept in economics that can explain a lot of behavior we see around us – from why high-income people almost never use the bus (due to the high opportunity cost of their time, which actually makes the bus very expensive relative to airplanes) to why hotel rooms in Manhattan are so much smaller than rooms in Houston (due to the high opportunity cost of land in Manhattan compared to Houston.)

In fact, the concept of opportunity cost is so powerful that it leads to an alternate explanation of the behavior of Iran's government in recent years. When the Iranian government announces that it wants uranium enrichment in order to have nuclear power, many people scoff at the idea. "Why," they say, "would the Iranians want nuclear power? Look at all the oil they have." Here's the way the U.S. Joint Economic Committee put it in the opening sentence of a March 2006 report [.pdf]:

"Iran's vast oil and gas resources undermine the Iranian regime's claim that its nuclear program is needed for domestic energy generation."

But these oil and gas resources don't undermine the regime's claim at all, as the concept of opportunity cost makes clear. Now it's possible that the Iranian government is lying: it is, after all, a government, and governments around the world often tell lies. But it's also possible that the Iranian government is telling the truth. And opportunity cost is the relevant concept that helps us see how.

Just as in the example above, Iran may find its oil less valuable in generating power than in selling on the world market. The numbers for Iran are similar to the hypothetical numbers I gave above. In 2005, Iran produced 4.2 million barrels per day and exported two-thirds of its barrels, or 2.7 million barrels per day. That Iran would want to consider exporting even more is especially easy to understand when you consider that world oil prices this year have averaged more than $60 a barrel, which is, adjusted for inflation, about double the world price as recently as 2003. Iran's opportunity cost for oil has risen.

None of this is to justify the Iranian government's building nuclear power plants for peaceful uses. Socialism in the energy industry is a bad idea whether practiced by the U.S. government, the Russian government, or the Iranian government. But the above reasoning can explain why the Iranian government might want to produce nuclear power for peaceful uses.

Again, I emphasize that I don't know enough about the situation to know what the Iranian government's motive is for wanting to go more nuclear. But my point is a narrower one: you can't simply, as the U.S. Joint Economic Committee did, observe two facts – that the Iranian government wants more nuclear production and that Iran is a net exporter of oil to the world – and conclude that, of course, Iran's goal is to have nuclear weapons. The concept of opportunity cost explains why.

Copyright © 2006 by David R. Henderson. Requests for permission to reprint should be directed to the author or Antiwar.com.

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David R. Henderson is a research fellow with the Hoover Institution and an associate professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School. He is author of The Joy of Freedom: An Economist’s Odyssey and co-author, with Charles L. Hooper, of Making Great Decisions in Business and Life (Chicago Park Press.) His latest book is The Concise Encyclopedia of Economics (Liberty Fund, 2008.)

He has appeared on The O’Reilly Factor, the Jim Lehrer Newshour, CNN, and C-SPAN. He has had over 100 articles published in Fortune, the Wall Street Journal, Red Herring, Barron’s, National Review, Reason, the Los Angeles Times, USA Today, and the Christian Science Monitor. He has also testified before the House Ways and Means Committee, the Senate Armed Services Committee, and the Senate Committee on Labor and Human Resources. Visit his Web site.

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