Opportunity cost

In microeconomic theory, the opportunity cost, also known as alternative cost, of making a particular choice is the value of the most valuable choice out of those that were not taken. When an option is chosen from two mutually exclusive alternatives, the opportunity cost is the "cost" incurred by not enjoying the benefit associated with the alternative choice. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen." Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in attempts to ensure that scarce resources are used efficiently. Opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered an opportunity cost.

Opportunity cost of a product or service means the revenue that could be earned by its alternative use. In other words opportunity cost is the cost of the next best alternative of a product or service. The meaning of the concept of opportunity cost can be explained with the help of following examples:

(1) The opportunity cost of the funds tied up in the one's own business is the interest (or profits corrected for differences in risk) that could be earned on those funds in other ventures.

(2) The opportunity cost of the time one puts into his own business is the salary he could earn in other occupations (with a correction for the relative psychic income in the two occupations).

(3) The opportunity cost of using a machine to produce one product is the earnings that would be possible from other products.

(4) The opportunity cost of using a machine that is useless for any other purpose is nil, since its use requires no sacrifice of other opportunities.

Thus opportunity cost requires sacrifices. If there is no sacrifice involved in a decision, there will be no opportunity cost. In this regard the opportunity costs not involving cash flows are not recorded in the books of accounts, but they are important considerations in business decisions.

History

The term was first used in 1914 by Austrian economist Friedrich von Wieser in his book Theorie der gesellschaftlichen Wirtschaft (Theory of Social Economy). The idea had been anticipated by previous writers including Benjamin Franklin and Frédéric Bastiat. Franklin coined the phrase "Time is Money", and spelt out the associated opportunity cost reasoning in his “Advice to a Young Tradesman” (1748): “Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.”

Bastiat's 1848 essay "What Is Seen and What Is Not Seen" used opportunity cost reasoning in his critique of the broken window fallacy, and of what he saw as spurious arguments for public expenditure.

Opportunity costs in production

Explicit costs

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

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

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.

If someone loses the opportunity to earn money, that is part of the opportunity cost. If someone chooses to spend money, that money could be used to purchase other goods and services so the spent money is part of the opportunity cost as well. Add the value of the next best alternative and you have the total opportunity cost. If you miss work to go to a concert, your opportunity cost is the money you would have earned if you had gone to work plus the cost of the concert.

Example

Question

Suppose that you have a free ticket to a concert by Band X. The ticket has no resale value. On the night of the concert your next-best alternative entertainment is a performance by Band Y for which the tickets cost $40. You like Band Y and would usually be willing to pay $50 for a ticket to see them. What is the opportunity cost of using your free ticket and seeing Band X instead of Band Y?

Answer

The benefit you forgo (that is, the value to you) is $10: the $50 benefit of seeing Band Y minus the ticket cost of $40.

See also

• Budget constraint
• Economic value added
• Fear of missing out
• Opportunity cost of capital
• Parable of the broken window
• Production-possibility frontier
• There ain't no such thing as a free lunch
• Time management
• Trade-off
• Best alternative to a negotiated agreement

External links

• The Opportunity Cost of Economics Education by Robert H. Frank