-As an economic tool

Suhana
XI-M
Roll No. 35
 Opportunity Cost- An Introduction

Economics is the study of how people make choices under scarcity.

Scarcity means that resources are limited. There are not enough resources available to satisfy
everyone’s wants. One’s income is limited and he/she cannot buy everything he/she wants, so
he/she must choose between different alternatives. Similarly, One’s time is also limited and he/she
cannot do everything he/she wants to, so he/she is forced to choose between different alternatives.

Because resources are scarce but wants are unlimited, people must make choices. This lesson show
cases the most important concept of economics, i.e, the concept of Opportunity Cost.

To get the most out of life, to think like an economist, One has to know what he’s giving up in order
to get something else….

Sometimes people are very happy holding on to the naive view that something is free. We like the
idea of a bargain. We don’t want to hear about the hidden or non-obvious costs. Thinking
about foregone opportunities, the choices we didn’t make, can lead to regret. Choosing this
college means you can’t go to that one. Marrying this person means not marrying that one.

Opportunity cost refers to what you have to give up to buy what you want in terms of other
goods or services.
Opportunity Cost- The Concept
Every choice has a value. Value has two parts

1. Benefits
2. Cost
 Importance of the Concept of Opportunity Cost
1. Determination of Relative Prices of goods

The concept is useful in the determination of the relative prices of different goods. For example, if a given
amount of factors can produce one table or three chairs, then the price of one table will tend to be three times
equal to that one chair.

2. Fixation of Remuneration to a Factor

The concept is also useful in fixing the price of a factor. For example, let us assume that the alternative
employment of a college professor is work as an officer in an insurance company at a salary of Rs. 40,000 per
month. In such a case, he has to be paid at least Rs.40,000 to continue to retain him in the college.

3. Efficient Allocation of Resources

The concept is also useful in allocating the resources efficiently. Suppose, opportunity cost of 1 table is 3
chairs and the price of a chair is Rs.1000, while the price of a table is Rs. 4000. Under such circumstances, it
is beneficial to produce one table rather than 3 chairs. Because, if he produces 3 chairs, he will get only Rs.
3000, whereas a table fetches him Rs. 4000, that is, Rs.1000 more.
 Limitations of the Concept of Opportunity Cost
The concept has the following drawbacks:

1. Specific
If a factor’s service is specific, it cannot be put to alternative uses. The alternative cost in
such a case is zero.
2. Inertia
Sometimes, factors may be reluctant to move to alternative occupations. In such a case, a
payment exceeding the pure transfer cost will have to be made to induce it to take to an
alternative occupation.
3. Perfect Competition
The concept rests on the assumption of perfect competition. However, perfect competition is
a myth, which seldom prevails.
4. Private and Social Costs
A discrepancy is likely to arise between private and social costs. For example, a chemical
factory discharges industrial refuse into a river. This causes serious health hazards, which
cannot be measured in money terms.
5. Alternatives are not clearly known
The foregone opportunities are often not ascertainable. This also poses a serious limitation
of the concept.
Opportunity Cost This concept of scarcity leads to the idea of opportunity cost. The opportunity cost of an
action is what you must give up when you make that choice. Another way to say this is: it is the value of the
next best opportunity. Opportunity cost is a direct implication of scarcity. People have to choose between
different alternatives when deciding how to spend their money and their time. Milton Friedman, who won
the Nobel Prize for Economics, is fond of saying "there is no such thing as a free lunch." What that means is
that in a world of scarcity, everything has an opportunity cost. There is always a trade-off involved in any
decision you make. The concept of opportunity cost is one of the most important ideas in economics.
Consider the question, “How much does it cost to go to college for a year?” We could add up the direct costs
like tuition, books, school supplies, etc. These are examples of explicit costs, i.e., costs that require a money
payment. However, these costs are small compared to the value of the time it takes to attend class, do
homework, etc. The amount that the student could have earned if she had worked rather than attended
school is the implicit cost of attending college. Implicit costs are costs that do not require a money payment.
The opportunity cost includes both explicit and implicit costs. Explicit costs are costs that require a money
payment. Implicit costs are costs that do not require a money payment. Opportunity cost includes both
explicit and implicit costs. The notion of opportunity cost helps explain why star athletes often do not
graduate from college. The cost of going to school includes the millions of dollars they could earn as a
professional athletes. If Kobe Bryant had decided to attend college for four years after high school instead of
signing with the Lakers, his implicit cost would have been over $10 million, the salary he earned in his first
four years as a Laker.
Economic Profits and Accounting Profits Economists use opportunity costs to understanding the behavior of
firms as well as individuals. The goal of the firm is to maximize profit. Profit is equal to revenue minus cost:
Profit = Total Revenue - Total Cost When economists refer to cost, they mean opportunity cost. The firm’s
cost of production includes explicit costs, like payroll, cost of raw materials and other direct costs. But it also
includes implicit costs. One of the most important implicit costs is associated with the firm’s capital. For
example, consider Josephine Csun, who starts a business with $100,000 she inherited from her rich uncle.
The opportunity cost of this capital is what Josephine could have earned if she had taken the money and
invested it elsewhere. If the rate of return on her best alternative investment opportunity is 10%, the implicit
cost of capital is $10,000. This would be added to her other explicit costs of doing business to compute the
opportunity cost. Accountants also compute costs. However, the costs that appear on an accountant’s
balance sheet are only explicit costs. The firm’s accounting profit is equal to total revenue minus explicit
costs. In the above example, an accountant would not count the $10,000 in income that Josephine is giving
up because she chose to use her $100,000 to start her own business rather than investing it elsewhere.
However, if Josephine had no rich uncle and had to borrow the $100,000 from the bank at 10% interest, the
interest payment of $10,000 would appear as an explicit cost. Economic profit is total revenue minus
opportunity cost. Accounting profit is total revenue minus explicit cost. Opportunity costs are higher than
explicit costs because opportunity costs also include implicit costs. As a result, economic profits are lower
than accounting profits. Accountants do not include implicit costs because they are difficult to measure. An
accountant does not always know what investment opportunity was given up to use the money to start a
business, but this does not mean opportunity costs are unimportant. Firms and individuals use them to make
key decisions. For example, consider Farmer Jones who owns a 100-acre farm. Farmer Jones is also a well-
known banjo player in the area and could earn $20 an hour giving banjo lessons. If he plants $100 worth of
seed, which takes 10 hours, the wheat produced can be sold for $400. An accountant would count the cost of
producing wheat as $100 and calculate an accounting profit of $300. However, an economist would calculate
the cost of producing wheat as $300. This $300 opportunity cost includes both the $100 explicit cost of seed
and the $200 implicit cost of Farmer Jones giving up teaching banjo lessons to plant wheat. Farmer Jones
earns an economic profit of $100 ($400 minus $300), which is lower than his accounting profit of $300 ($400
minus $100). If Farmer Jones could hire alaborer to plant his wheat for $5/hour, he should do so. His
economic profit would increase even though his explicit costs would rise, because he would now be free to
earn $20/hour giving banjo lessons. Summary: The opportunity cost of any decision is what is given up as a
result of that decision. Opportunity cost includes both explicit costs and implicit costs. The firm’s economic
profits are calculated using opportunity costs. Accounting profits are calculated using only explicit costs.
Therefore, accounting profits are higher than economic profits.
Opportunity costs in production[edit]
Explicit costs[edit]
Explicit costs are opportunity costs that involve direct monetary payment by producers. The explicit opportunity cost
of the factors of production not already owned by a producer is the price that the producer has to pay for them. For
instance, if a firm spends $100 on electrical power consumed, its explicit opportunity cost is $100. This cash
expenditure represents a lost opportunity to purchase something else with the $100.

Implicit costs[edit]
Implicit costs (also called implied, imputed or notional costs) are the opportunity costs that are not reflected in cash
outflow but are implied by the choice of the firm not to allocate its existing (owned) resources, or factors of
production, to the best alternative use. For example: a manufacturer has previously purchased 1000 tons of steel
and the machinery to produce a widget. The implicit part of the opportunity cost of producing the widget is the
revenue lost by not selling the steel and not renting out the machinery instead of using it for production.
One example of opportunity cost is in the evaluation of "foreign" (to the US) buyers and their allocation of cash
assets in real estate or other types of investment vehicles. During the downturn in circa June or July 2015 of the
Chinese stock market, more and more Chinese investors from Hong Kong and Taiwan turned to the United States
as an alternative vessel for their investment dollars; the opportunity cost of leaving their money in the Chinese stock
market or Chinese real estate market is the yield available in the US real estate market.

Evaluation[edit]
Opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive
to each other. It is the highest value option forgone. The opportunity cost of a city's decision to build the hospital on
its vacant land is the loss of net income from using the land for a sporting center, or the loss of net income from
using the land for a parking lot, or the money the city could have made by selling the land, whichever is greatest.
Use for any one of those purposes precludes all the others.

https://www.econlib.org/library/Topics/College/opportunitycost.html

https://study.com/academy/lesson/opportunity-cost-definition-calculations-examples.html

https://en.wikipedia.org/wiki/Opportunity_cost

https://www.slideshare.net/IvanSiananda/opportunity-cost-9532670

https://owlcation.com/social-sciences/Meaning-of-Opportunity-Cost-and-Its-Economic-Significance