Theory of Cost

What is Opportunity Cost?

Opportunity cost in economics can be defined as benefits or value missed out by business owners, small businesses, organization, investors, or an individual because they choose to accomplish or achieve anything else. It helps organizations in better decision-making by showing the lost opportunity because of investing over an alternative which can be anything like shares, stock market, real estate, land, services, etc. Generally, the financial report does not show the opportunity cost because it is not only about money or monetary cost. It is also associated with the lost time invested somewhere else which is providing utility. In simple terms, it is a concept in microeconomics that tells you about the output and potential opportunities foregone.

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It shows the relation between choice and scarcity. In this article, we will learn more about examples, formula, explicit cost, implicit cost, and concept of opportunity cost in managerial economics.

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Definition of Opportunity Cost in Economics

In modern economic analysis, the factors of production are scarce as compared to the wants.

Therefore, when society uses a certain factor in the production of a specific commodity, then it forgoes other commodities for which it could use the same factor. This led to the idea of an opportunity cost (OC).

Let’s say that a certain kind of steel is needed to manufacture weapons for war. Therefore, society has to give up the number of utensils that it could produce using the same amount of steel.

Hence, the opportunity cost of producing weapons for war is the number of utensils forgone.

diagram of opportunity cost

In other words, opportunity costs are the costs of the next best alternative forgone. Therefore, we can deduce two important aspects:

  1. The opportunity costs of a product are only the best alternative forgone and not any other alternative.
  2. These costs are viewed as the next-best alternative goods that we can produce with the same value of factors which are more or less the same.

Learn more about Cost Concept here in detail

How to Calculate Opportunity Cost

Formula of Opportunity cost = Return of Investment from the best option available – Return of investment from the chosen option.

Examples of Opportunity Cost

Let’s understand these costs with the help of an illustration.

Let’s say that a farmer has a piece of land on which he can grow wheat or rice.

Therefore, if he chooses to grow wheat, then he cannot grow rice and vice-versa.

Hence, the opportunity cost for rice is the wheat crop that he forgoes. The following diagram explains this:

Opportunity Cost Graph –

opportunity cost graph

Let’s assume that the farmer can produce either 50 quintals of rice (ON) or 40 quintals of wheat (OM) using this land. Now, if he produces rice, then he cannot produce wheat.

Therefore, the OC of 50 quintals of rice (ON) is 40 quintals of wheat (OM).

Further, the farmer can choose to produce any combination of the two crops along the curve MN (production possibility curve). Let’s say that he chooses the point A as shown above.

Therefore, he produces OD amount of rice and OC amount of wheat. Subsequently, he decides to shift to point B. Now, he has to reduce the production of wheat from OC to OE in order to increase the production of rice from OD to OF.

Therefore, the OC of DF amount of rice is CE amount of wheat.

Applications of Opportunity Cost

  • Determining factor prices
  • Determining economic rent
  • Consumption pattern decisions
  • Determining factor prices
  • Product plan decisions
  • Decisions about national priorities

Determining factor prices

The factors for production need a price equal to or greater than what they command for alternative uses. If the factor price is less than the factor’s opportunity cost, then the said factor moves to the better-paying alternative.

Determining economic rent

Many modern economists use this concept for determining economic rent. As per them, economic rent = The factor’s actual earning – Its opportunity cost or transfer earning

Consumption pattern decisions

According to this concept, if with a given amount of money a consumer chooses to have more of one thing, then he needs to have less of the other.

Further, he cannot increase the consumption of all the goods at the same time. Therefore, he decides his consumption pattern using the concept of opportunity cost.

Product plan decisions

Let’s say that a producer has fixed resources and technology. If he wants to produce a greater amount of one commodity, then he must sacrifice the quantity of another commodity.

Therefore, he uses this concept to make decisions about his production plan.

Decisions about national priorities

Every country has certain resources at its command and needs to plan the production of a wide range of commodities. This decision depends on the national priorities which are based on opportunity costs.

For example, if a country is at war, then it will use its resources to produce more war-related goods as compared to civilian goods.

This concept helps the country in making these decisions.

What is the Difference between Sunk Cost and Opportunity Cost?

The sunk cost can be defined as the financial cost which is already invested and now it cannot be incurred or money you cannot get back.

For example, if a company purchases 1000s of laptops for $1000000, then that money is sunk i.e. the company cannot get the money back for those laptops. To get that money back we need to get the amount higher than the purchase price.

Opportunity cost is how much less return of investment a company received because of investing capital somewhere else.

Types of Opportunity Cost in Production

  • Explicit Cost
  • Implicit Cost
  • Marginal Opportunity Cost

What is Explicit Cost?

Explicit costs are the cost which includes the monetary payment from the producers. For example, if the company is paying $1000 per month in food by providing free lunch and breakfast, then its explicit OC is $1000. The expenditure on food could have been used somewhere else.

What is Implicit Cost?

Implicit cost aka notional cost can be defined as the OC which a company used in order to produce something. For example, a company purchased small electronic devices to produce mobile phones, laptops, etc. This cost is used to produce something, the electronic devices are not sold or rented.

What is Marginal Opportunity Cost?

Marginal opportunity cost is a cost required to produce something extra. For example, currently a company is producing 1000 burgers per day, but due to heavy demand, they are running out of the burgers. So, the company decided to hire more people and cook more burgers.

Now marginal opportunity cost will include – payment of new employees, cost required for ingredients required to cook more burgers,  profit company was missing before and many other extra costs required for producing additional burgers.

Questions on Opportunity Cost

Q1. Explain the concept of an opportunity cost

Answer: When a producer uses a certain factor in the production of a specific commodity, then he forgoes the production of other commodities for which he could use the same factor. The amount of the commodity that he forgoes is the OC of the amount of extra production of the specified commodity.

Q2. What does Opportunity cost tell you?

Answer: OC tells you the lesser ROI you have received compared to if you would have invested somewhere else i.e. missed the opportunity to earn more.

Q3. Can Opportunity cost be zero?

No, OC can never be zero.

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