Concept of Opportunity Cost
Opportunity cost is commonly defined as the next best alternative. Also, known as the alternative cost, it is the loss of gain which could have been gained if another alternative was chosen. It can also be explained as the loss of benefit due to a change in choice.
Opportunity cost is an economic concept arising out of the realistic assumption of the scarcity of resources. The limited amount of resources will also limit the number of possibilities for production. As the number of possibilities of production is limited, to produce a given combination of goods, the production of another combination of goods would have to be forgotten. This can be referred to as opportunity cost.
Opportunity cost is a concept that is widely used by promoters and business analysts to conduct feasibility studies as well as to ascertain policy decisions to be taken.
Opportunity Cost of Decisions
Every opportunity cost is due to a faulty decision. The better the decision is, the smaller the opportunity cost will be. An opportunity cost can be found in any daily activity. The homework you did not do could be the opportunity cost of sleeping more. Even though you prefer sleeping, the homework makes you more productive and may fetch you more marks.
In economics, the opportunity cost of decisions generally pertains to the opportunity cost arising due to the decisions of the firm in production. This decision on the choice of production occurs due to the scarcity of resources. For example, a farmer has a fixed area of land in which she cultivates different crops. If the farmer sows rice at a particular time, she can’t produce wheat now as she has already used up her land to produce rice. The gain that the farmer would have earned by cultivating wheat over and above her earnings by sowing rice is her opportunity cost.
This opportunity cost arose due to two main reasons - the limited area of land with the farmer and her decision to sow rice instead of wheat. If the farmer had an unlimited area of land and unlimited units of labor with her, she could have produced any quantity of both rice and wheat. And if she had decided to produce wheat instead of rice she would have earned more than she does now.
Calculation of Opportunity Cost
Opportunity cost is the extra return on an alternative available over and above the chosen option.
Therefore, Opportunity cost = Return from the best alternative – Return from the already selected option
This calculation of opportunity cost has a wide range of applications. Most prominently being used in product planning decisions, the concept of opportunity cost is relevant in many other business scenarios. The calculation method is used when prices paid to factor services are determined and also to calculate economic rent, which is the difference between the actual return to factor services and their supply price.
The calculation of opportunity cost is not only applicable to the producers. The consumers also use the method of opportunity cost to weigh different consumption bundles among each other.
Types of Opportunity Costs
There are broadly two types of opportunity costs. They are explicit costs and implicit costs.
Explicit costs are as the name suggests direct costs that can be identified clearly. The explicit costs are incurred and recorded in the books of accounts. These explicit costs would have to be paid in cash or kind. For example, if a piece of machinery in the firm malfunctions, the repairing cost is explicit. The repairing and reinstalling work will have to be paid in cash and the transaction is charged in the books of accounts as an expenditure.
Implicit costs are indirect or invisible costs that cannot be directly or easily traced down. The implicit costs affect the firm as the loss of its owned resources. Payments are not usually made as there is no real cost. For example, if in a firm a piece of machinery breaks down as mentioned earlier, in addition to the cost of repairing which is an explicit cost there is also an implicit cost of loss in production. The production in that unit is stalled as the machinery is not working and, in the meantime, other valuable resources like human resources are being wasted.
What is the Increasing Opportunity Cost?
The concept of increasing opportunity cost is usually seen in the production possibility frontier which shows the possibility of production of different bundles of two goods using a limited amount of resources. The Production Possibility Frontier is concave to the origin and its slope is the opportunity cost. As the PPF is concave to the origin, it shows how the opportunity cost of producing more of one good continuously increases. This increasing nature of opportunity cost is generally explained in terms of the inefficiency of resources when put to work to produce more than one kind of good.
For example, in an economy, steel can be used for making utensils as well as weapons. As more and more steel is used in the production of weapons and less on utensils, the opportunity cost goes on decreasing. This is because the amount of other resources employed in the production of weapons, namely machinery, is fixed and as more and more steel is fed into the limited amount of machinery, it becomes inefficient.
Introduction to Opportunity cost
It was firstly introduced by the 18th-century economist, Adam Smith. When it comes to opportunity cost, there are three factors that you need to take into account: The value of the option that you're giving up; The likelihood of achieving the desired outcome; And your level of certainty about both options. Opportunity cost is important because it helps us make better decisions and encourages us to think about the future for example when choosing a course of action in business. It can also help determine whether or not pursuing something particular is worth doing based on its potential benefits and what we might have to sacrifice instead.
Opportunity Cost is Important Because
1. It's a measure of the cost of alternatives like sacrificing short-term profits
2. It is used to analyze the potential of an opportunity
3. And it can help you determine whether or not a particular course of action is worth pursuing.
4. It can help you make better decisions
5. It helps to assess opportunity costs and benefits.
6. It encourages you to think about the future.
Here are Some Tips to Study Opportunity Cost
1) Know the Basics- Before starting studying the concept, it is important to have a clear understanding of what it is all about and be familiar with the common terminologies. Which will help you focus on the concept itself.
2) Learn the Rules- There are some rules that you need to follow in order to get accurate results and avoid making mistakes when calculating opportunity costs. You should always use real numbers instead of percentages or fractions for simplifying the calculation process without confusion. When choosing your timing, consider how long an activity takes and when its benefits begin. Avoid cramming - Write down concepts clearly before moving over them so that there won't be any difficulty while practicing later on during exam time!
3) You need to make sure that the correct time period is used. When choosing your timing for opportunity cost calculations, it's important to consider how long an activity takes and when its benefits begin.
4) You should always use real numbers instead of percentages or fractions in order to simplify the calculation and avoid confusion.
5) Avoid Cramming- When it comes to studying, especially for something like opportunity cost where there are a number of complex terms. It is best to make sure that you write them down and understand the concept fully before moving on.
6) Practice Makes Perfect- It is important to practice the calculation because there are a number of different ways to calculate opportunity cost. There are online calculators that you can use or even practice problems to help you better understand the concept.
It is Applied in Various Ways
Opportunity cost is a basic economic principle that applies to businesses as well. It's important to learn and understand the concept in order to make better decisions for your business. The best way to do this is by studying and practicing, which will help you get a clear understanding of how it works.
When making financial decisions, it's important to consider opportunity cost - the amount of money that you have to spend in order to get something else. Opportunity cost is a basic economic principle that applies to businesses as well. Essentially, it's what you give up when pursuing an alternative course of action.
FAQs on Opportunity Cost: Definition and Examples
1. What is opportunity cost in economics? Explain with an example.
In economics, opportunity cost represents the value or benefit of the next-best alternative that is given up when making a choice. Since resources like time, money, and materials are scarce, every decision involves a trade-off. The opportunity cost is the cost of that trade-off.
For example, a farmer has a piece of land where they can grow either wheat or rice. If they choose to grow wheat, the opportunity cost is the potential profit they would have earned from growing rice, which is the next-best alternative.
2. How is opportunity cost calculated using a formula?
Opportunity cost is calculated to quantify the value of the forgone option. While not always a simple monetary calculation, for financial decisions it can be expressed with a formula:
Opportunity Cost = Return of the Next Best Alternative - Return of the Chosen Alternative
For instance, if you have ₹10,000 and can either invest in stocks with an expected return of ₹1,200 or in bonds with a return of ₹800, and you choose the stocks, your opportunity cost is not ₹800. The concept focuses on the gain from the forgone option, so the opportunity cost is the ₹800 you gave up by not choosing the bonds.
3. What are the main types of opportunity cost mentioned in the CBSE Class 11-12 syllabus?
Opportunity costs can be broadly categorised into two main types, which are essential for understanding a firm's total economic costs:
- Explicit Costs: These are the direct, out-of-pocket payments made by a firm for resources, such as wages for employees, rent for a building, and the cost of raw materials. These are the costs that are typically recorded in a company's accounting ledgers.
- Implicit Costs: These are the opportunity costs of using resources that the firm already owns, rather than paying for them. For example, if a business owner uses their personal building for their office instead of renting it out, the implicit cost is the rental income they have forgone.
4. Can you provide some examples of opportunity cost in a student's daily life?
Yes, opportunity cost is a concept that applies to everyday decisions, not just business or economics. Here are a few examples for a student:
- Studying vs. Socialising: If you spend an evening studying for an important exam, the opportunity cost is the enjoyment and social connection you miss out on by not going out with friends.
- Part-time Job vs. Extra-curriculars: Choosing to take a part-time job for income means the opportunity cost might be the skills, experience, and enjoyment you would have gained from joining the school's debate team or sports club.
- Choosing a Subject Stream: When a student chooses the Commerce stream, their opportunity cost is the potential career paths and knowledge they would have acquired by choosing the Science or Arts stream.
5. Why is the concept of opportunity cost important for making business decisions?
Understanding opportunity cost is crucial for effective business decision-making because it helps in the efficient allocation of scarce resources. It encourages businesses to look beyond just the explicit costs of a project and consider the potential profits from alternative investments. Its importance is seen in areas like:
- Production Planning: Deciding which products to manufacture with limited factory capacity.
- Capital Budgeting: Evaluating whether to invest in a new project or put the money into marketable securities. The potential return from the securities is the opportunity cost of capital.
- Resource Allocation: Determining the best use of employees, machinery, and funds to maximise overall returns.
6. How does a Production Possibility Curve (PPC) illustrate the concept of increasing opportunity cost?
A Production Possibility Curve (PPC) is typically drawn as concave to the origin, which directly illustrates the principle of increasing opportunity cost. Here's how:
- A PPC shows the different combinations of two goods that can be produced with given resources and technology.
- As an economy moves along the curve to produce more of one good (e.g., Good X), it must give up some production of the other good (Good Y).
- The concave shape shows that to produce each additional unit of Good X, an ever-increasing amount of Good Y must be sacrificed. This happens because resources are not equally efficient in producing all goods. Initially, resources best suited for Good X are shifted. Later, resources better for Good Y are shifted, leading to a larger drop in the production of Good Y. This increasing sacrifice is the increasing opportunity cost.
7. Is opportunity cost always a monetary value?
No, opportunity cost is not always a monetary value. It is a broader concept that represents the value of the next-best alternative, which can be non-monetary. Many important decisions involve trade-offs with intangible benefits. For example, the opportunity cost of working long hours might be reduced leisure time, family time, or personal health, none of which have an exact price tag but hold significant value.
8. What is the fundamental difference between opportunity cost and accounting cost?
The fundamental difference lies in what they include. Accounting cost refers only to the explicit costs of a business—the direct monetary payments for inputs like wages, rent, and materials. It's what is recorded for financial reporting.
In contrast, economic cost provides a more complete picture by including both explicit costs and implicit costs. Opportunity cost is the most significant part of implicit costs. Therefore, while an accountant might see a business as profitable by only looking at revenue minus explicit costs, an economist might see it as unprofitable if the owner's forgone salary and investment returns (opportunity costs) are higher than the accounting profit.
9. What are some limitations of using opportunity cost in practical decision-making?
While a powerful concept, opportunity cost has some practical limitations:
- Lack of Information: It can be difficult to accurately know the potential outcome or value of the alternative you are giving up.
- Subjectivity: The value of non-monetary alternatives, like the enjoyment of a holiday, is highly subjective and differs from person to person.
- Multiple Alternatives: The model simplifies the choice to the single 'next-best' alternative, but real-world decisions often involve evaluating numerous complex options simultaneously.
- Quantification Issues: It is hard to assign a reliable numerical value to intangible factors like brand image or employee morale, which can also be opportunity costs.
