An important part of being a rational decision maker is considering opportunity costs. Opportunity cost is the forgone benefit that would have been derived by an option not chosen. In our introductory part we have identified the concept of scarcity. When it comes to resources and money, we are usually quite good at considering scarcity. What we are less good at considering is lack of time.
The concept of cost is an important concept in economics. It refers to the amount of payment made for obtaining any goods and services. In a simple way, the concept of cost is the financial assessment of the resources, materials, risks, time and utilities expended to purchase goods and services. From an economist’s point of view, the cost of manufacturing any goods and services is often called the concept of opportunity cost.
With the increased competition in today’s world, companies urge to earn maximum profits. A company’s decision to maximize earnings depends on its cost and revenue behaviour. Apart from the concept of opportunity cost, there are many other concepts of cost such as fixed cost, explicit cost, social cost, implicit cost, social cost and replacement cost.
What is Opportunity Cost?
Meaning of Opportunity Cost: – Opportunity cost is the value of something when a particular task is chosen. Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. The benefit or value that was given can refer to decisions in your personal life, in a company, in the economy, in the environment, or at the government level.
Opportunity cost is the cost of making one decision over another. To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others. Considering the value of opportunity costs can guide individuals and organizations to more profitable decision-making.
Formula and Calculation of Opportunity Cost
Opportunity Cost = FO (returns on best forgone option) − CO (returns on chosen option)
What is an example of opportunity cost?
Consider the case of an investor who, at the age of 18, was encouraged by their parents to always put 100% of their disposable income into bonds. Over the next 50 years, this investor did investment of $5,000 per year in bonds, achieving an average annual return of 2.50% and retiring with a portfolio worth nearly $500,000. Although this result might seem impressive, it is less so when one considers the investor’s opportunity cost. If, for example, they had instead invested half of their money in the stock market and received an average blended return of 5%, then their retirement portfolio would have been worth over $1 million.
More examples of Opportunity cost: –
- One skip watching a movie to study for an exam to get good grades. Opportunity cost is the cost of the film and the pleasure of watching it.
- In the ice cream parlour, you have to choose between a rocky road and a strawberry. When you choose a rocky road, there was an opportunity cost to enjoy strawberries.
- Instead of taking a vacation, a player attends baseball training to become a better player. The opportunity cost was vacation.
What are the applications of Opportunity Cost?
The applications of Opportunity Cost are as follows: –
- 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 are the types of opportunity costs?
There are three types of Opportunity cost in production, as follows: –
- Explicit Cost
- Implicit Cost
- Marginal Opportunity Cost
Meaning of Explicit Cost: – An explicit cost is a clearly stated cost that a business incurs. Explicit costs are normal business costs that appear in the general ledger and directly affect a company’s profitability. Explicit costs are easy to identify, record, and audit because of their paper trail. For example, employee salary, bonus, commision, inputs, taxes, utility bills and rent, Advertising and marketing costs among others. These are the costs that are reported on businesses’ balance sheets.
Meaning of Implicit Cost: – An implicit cost is any cost that has already occurred but is not necessarily shown or reported as a separate expense. It represents an opportunity cost that arises when a company uses internal resources for a project without any explicit compensation for the resources used. This means that when a company allocates its resources, it is always giving up its ability to make money from the use of resources elsewhere, so there is no exchange of cash. An implicit cost is a cost that exists without the exchange of cash and is not recorded for accounting purposes. For example, Lost interest on money occurs when the firm employs its capital, training a new employee presents an inherent cost, a small business owner who may forgo a salary in the early stages of operations to reduce cost and increase revenue.
Meaning of Marginal Cost: – In economics, marginal cost of production is the change in total production cost that comes from producing or producing an additional unit. It refers to the incremental cost of adding one more unit of production, such as producing one more product or delivering one more service to customers. It is generally associated with manufacturing businesses, although the concept can be applied to other types of businesses as well. Marginal Cost of Production is important because it can help businesses to optimize their production levels. Producing too much too quickly could negatively impact profitability, whereas producing too little can also lead to suboptimal results. Generally speaking, a company will reach optimal production levels when their Marginal Cost of Production is equal to their Marginal Revenue.
Marginal Cost = (Change in Costs) / (Change in Quantity)
Other concepts of costs
Meaning of Incremental Cost: – Incremental cost is the additional cost that a company incurs if it manufactures additional quantities of units. For example, consider a company that manufactures 100 units of its main product and decides that it can fit 10 more units into its production schedule. The additional cost that will be borne for the production of these 10 units is the incremental cost. For example, Changing the product line, Changing the level of product output, Buying additional or new materials, Hiring extra labour, Adding new machines or replacing existing ones, Switching distribution channels and Variable overhead costs.
Incremental costing is sometimes referred to as marginal costing, but there is a difference between the two. In marginal costing, you would consider the increased total cost that would arise from producing one more unit. When considering incremental costing, you only take into account total costs that change with your decision to produce additional units.
Meaning of Sunk Cost: – A sunk cost refers to money that has already been spent and cannot be recovered. In business, the principle of “spending money to make money” is reflected in the phenomenon of sunk costs. A sunk cost is different from future costs that a business may face, such as inventory purchase costs or decisions about product pricing. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. Examples of Sunk Cost: – Marketing, Research and development, Training and Hiring