Opportunity cost
Encyclopedia
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen (that is foregone). It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive
choices. The opportunity cost is also the cost of the foregone products after making a choice. 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 ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output foregone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.
The term was coined in 1914 by Friedrich von Wieser
in his book "". However, in 1848 Frédéric Bastiat
described this concept in his essay...What Is Seen and What Is Not Seen
In environmental protection
, opportunity cost is also applicable. This has been demonstrated in the legislation that required the carcinogenic aromatics (mainly reformate) to be largely eliminated from gasoline. Unfortunately, this required refineries to install equipment at a cost of hundreds of millions of dollars – and pass the cost to the consumer. The absolute number of cancer cases attributed to exposure to gasoline, however, is low, estimated a few cases per year in the U.S. Thus, the decision to require fewer aromatics has been criticized on the grounds of opportunity cost: the hundreds of millions of dollars spent on process redesign could have been spent on other, more fruitful ways of reducing deaths caused by cancer or automobiles. These actions (or strictly, the best one of them) are the opportunity cost of reduction of aromatics in gasoline.
The Opportunity Cost of consuming good x, relative to good y (x:y) can be calculated by the price of good y, relative to good x (Py/Px). For example, a movie (good x) costs $10 (Px) and bowling (good y) costs $20 (Py), the opportunity cost of going bowling is 2 movies (Px/Py = 20/10). That is the $20 spent on bowling could have been used to see two movies priced at $10. Conversely the opportunity cost of going to watch a movie is 0.5 (10/20) games of bowling. Units should be specified in the opportunity cost, for example if forgoing 3 party invitations to go out on a date you would not say "I passed on 3 for this date", your date would need to know the units of the good forgone for the statement to make sense.
not already owned by a producer is the price that the producer has to pay for them. For instance, a firm spends $100 on electrical power consumed, their opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.
and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price
) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action. Accounting cost includes only costs that have been explicitly incurred, whereas, economic cost includes opportunity costs. Similarly, this is a major difference between economic profit and accounting profit; opportunity cost being a variable in the calculation of economic profit.
Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of a city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land. Use for any one of those purposes would preclude the possibility to implement any of the other.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money. In some cases, it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier
. In microeconomic models this is unusual, because individuals are assumed to maximize utility, but it is a feature of Keynesian macroeconomics. In these circumstances, opportunity cost is a less useful concept.
Mutually exclusive
In layman's terms, two events are mutually exclusive if they cannot occur at the same time. An example is tossing a coin once, which can result in either heads or tails, but not both....
choices. The opportunity cost is also the cost of the foregone products after making a choice. Opportunity cost is a key concept in economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, and has been described as expressing "the basic relationship between scarcity
Scarcity
Scarcity is the fundamental economic problem of having humans who have unlimited wants and needs in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs. Alternatively, scarcity implies that not all of society's goals can be...
and choice
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
". The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output foregone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.
The term was coined in 1914 by Friedrich von Wieser
Friedrich von Wieser
Friedrich Freiherr von Wieser was an early member of the Austrian School of economics. Born in Vienna, the son of Privy Councillor Leopold von Wieser, a high official in the war ministry he first trained in sociology and law...
in his book "". However, in 1848 Frédéric Bastiat
Frédéric Bastiat
Claude Frédéric Bastiat was a French classical liberal theorist, political economist, and member of the French assembly. He was notable for developing the important economic concept of opportunity cost.-Biography:...
described this concept in his essay...What Is Seen and What Is Not Seen
Opportunity costs in consumption
Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be not enjoying the other program (such as Dynasty). If an individual records one program while watching the other, the opportunity cost will be the time that the individual spends watching one program versus the other. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. The opportunity cost of ordering both meals could be twofold: the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought of as greedy or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happier children could therefore be a remodeled bathroom.In environmental protection
Environmental protection
Environmental protection is a practice of protecting the environment, on individual, organizational or governmental level, for the benefit of the natural environment and humans. Due to the pressures of population and our technology the biophysical environment is being degraded, sometimes permanently...
, opportunity cost is also applicable. This has been demonstrated in the legislation that required the carcinogenic aromatics (mainly reformate) to be largely eliminated from gasoline. Unfortunately, this required refineries to install equipment at a cost of hundreds of millions of dollars – and pass the cost to the consumer. The absolute number of cancer cases attributed to exposure to gasoline, however, is low, estimated a few cases per year in the U.S. Thus, the decision to require fewer aromatics has been criticized on the grounds of opportunity cost: the hundreds of millions of dollars spent on process redesign could have been spent on other, more fruitful ways of reducing deaths caused by cancer or automobiles. These actions (or strictly, the best one of them) are the opportunity cost of reduction of aromatics in gasoline.
The Opportunity Cost of consuming good x, relative to good y (x:y) can be calculated by the price of good y, relative to good x (Py/Px). For example, a movie (good x) costs $10 (Px) and bowling (good y) costs $20 (Py), the opportunity cost of going bowling is 2 movies (Px/Py = 20/10). That is the $20 spent on bowling could have been used to see two movies priced at $10. Conversely the opportunity cost of going to watch a movie is 0.5 (10/20) games of bowling. Units should be specified in the opportunity cost, for example if forgoing 3 party invitations to go out on a date you would not say "I passed on 3 for this date", your date would need to know the units of the good forgone for the statement to make sense.
Opportunity costs in production
Opportunity costs may be assessed in the decision-making process of production. If the workers on a farm can produce either one million pounds of wheat or two million pounds of barley, then the opportunity cost of producing one pound of wheat is the two pounds of barley foregone. Firms would make rational decisions by weighing the sacrifices involved.Explicit costs
Explicit costs are opportunity costs that involve direct monetary payment by producers. The opportunity cost of the factors of productionFactors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
not already owned by a producer is the price that the producer has to pay for them. For instance, a firm spends $100 on electrical power consumed, their opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.
Implicit costs
Implicit costs are the opportunity costs that involve only factors of production that a producer already owns. They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms. For example, a firm pays $300 a month all year for rent on a warehouse that only holds product for six months each year. The firm could rent the warehouse out for the unused six months, at any price (assuming a year-long lease requirement), and that would be the cost that could be spent on other factors of production.Non-monetary opportunity costs
Opportunity costs are not always measured in monetary units or being able to produce one good over another. For instance, an individual could choose not to mow his or her lawn, in an attempt to create a prairie land for additional wild life. Neighbors of this individual may see this as unsightly, and want the lawn to be mowed. In this case, the opportunity cost of additional wild life is unhappy neighbors.Evaluation
The consideration of opportunity costs is one of the key differences between the concepts of economic costEconomic cost
The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost....
and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action. Accounting cost includes only costs that have been explicitly incurred, whereas, economic cost includes opportunity costs. Similarly, this is a major difference between economic profit and accounting profit; opportunity cost being a variable in the calculation of economic profit.
Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of a city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land. Use for any one of those purposes would preclude the possibility to implement any of the other.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money. In some cases, it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier
Production possibility frontier
In economics, a production–possibility frontier , sometimes called a production–possibility curve or product transformation curve, is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production...
. In microeconomic models this is unusual, because individuals are assumed to maximize utility, but it is a feature of Keynesian macroeconomics. In these circumstances, opportunity cost is a less useful concept.
See also
- Trade-offTrade-offA trade-off is a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect...
- Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Opportunity cost of capitalOpportunity cost of capitalThe opportunity cost of capital is the expected rate of return forgone by bypassing of other potential investment activities for a given capital.It is a rate of return that investors could earn in financial markets....
- Economic value addedEconomic value addedIn corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
- Invisible handInvisible handIn economics, invisible hand or invisible hand of the market is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith...
- MarginalismMarginalismMarginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity...
- Net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
- Parable of the broken windowParable of the broken windowThe parable of the broken window was introduced by Frédéric Bastiat in his 1850 essay to illustrate why destruction, and the money spent to recover from destruction, is actually not a net-benefit to society...
- Partial KnowledgeThe Use of Knowledge in Society"The Use of Knowledge in Society" is a scholarly article written by economist Friedrich Hayek, first published in the September 1945 issue of The American Economic Review Written as a rebuttal to fellow economist Oskar R...
- Production-possibility frontier
- There Ain't No Such Thing As A Free LunchTANSTAAFL"There ain't no such thing as a free lunch" is a popular adage communicating the idea that it is impossible to get something for nothing. The acronyms TANSTAAFL and TINSTAAFL are also used...
- Time managementTime managementTime management is the act or process of exercising conscious control over the amount of time spent on specific activities, especially to increase efficiency or productivity. Time management may be aided by a range of skills, tools, and techniques used to manage time when accomplishing specific...
External links
- The Opportunity Cost of Economics Education by Robert H. FrankRobert H. FrankRobert H. Frank is the Henrietta Johnson Louis Professor of Management and a Professor of Economics at the Samuel Curtis Johnson Graduate School of Management at Cornell University. He contributes to the "Economic View" column, which appears every fifth Sunday in The New York Times.-Career:Frank...
- Opportunity Cost Example & Analysis