Opportunity cost

Last updated

When an option is chosen from alternatives, the opportunity cost is the "cost" incurred by not enjoying the benefit associated with the best alternative choice. [1] The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen." [2] In simple terms, opportunity cost is the benefit not received as a result of not selecting the next best option. Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice". [3] The notion of opportunity cost plays a crucial part in attempts to ensure that scarce resources are used efficiently. [4] 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. The opportunity cost of a product or service is 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:

Contents

(1) The opportunity cost of the funds tied up in 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 1894 by David L. Green in an article in the Quarterly Journal of Economics entitled "Pain Cost and Opportunity-Cost. [5] The idea had been anticipated by previous writers including Benjamin Franklin and Frédéric Bastiat. Franklin coined the phrase "Time is Money", and spelled 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. [6]

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. [7]

See also

Related Research Articles

Frédéric Bastiat French classical liberal theorist, political economist, and member of the French assembly

Claude-Frédéric Bastiat was a French economist, writer and a prominent member of the French Liberal School.

In finance, the net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

Externality an impact on any party not involved in a given economic transaction or act

In economics, an externality is the cost or benefit that affects a third party who did not choose to incur that cost or benefit. Externalities often occur when the production or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. This causes the externality competitive equilibrium to not be a Pareto optimality.

Sunk cost costs that have already been incurred and cannot be recovered

In economics and business decision-making, a sunk cost is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, in everyday life, people often take previous expenditures in situations such as repairing a car or house into their future decisions regarding those properties.

Parable of the broken window Parable by French economist Frédéric Bastiat

The parable of the broken window was introduced by French economist Frédéric Bastiat in his 1850 essay "Ce qu'on voit et ce qu'on ne voit pas" to illustrate why destruction, and the money spent to recover from destruction, is not actually a net benefit to society.

Cost value of money that has been used up to produce something

In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production.

Environmental full-cost accounting (EFCA) is a method of cost accounting that traces direct costs and allocates indirect costs by collecting and presenting information about the possible environmental, social and economical costs and benefits or advantages – in short, about the "triple bottom line" – for each proposed alternative. It is also known as true-cost accounting (TCA), but, as definitions for "true" and "full" are inherently subjective, experts consider both terms problematical.

Friedrich von Wieser austrian economist

Friedrich Freiherr von Wieser was an early economist 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 1872, the year he took his degree, he encountered Austrian-school founder Carl Menger's Grundsätze and switched his interest to economic theory. Wieser held posts at the universities of Vienna and Prague until succeeding Menger in Vienna in 1903, where along with his brother-in-law Eugen von Böhm-Bawerk he shaped the next generation of Austrian economists including Ludwig von Mises, Friedrich Hayek and Joseph Schumpeter in the late 1890s and early 20th century. He was the Austrian Minister of Commerce from August 30, 1917 to November 11, 1918.

Personal finance process of anticipating the wealth of an individual, his or her family, a business or a trust

Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.

A Pigovian tax is a tax on any market activity that generates negative externalities. The tax is intended to correct an undesirable or inefficient market outcome, and does so by being set equal to the social cost of the negative externalities. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. Often-cited examples of such externalities are environmental pollution, and increased public healthcare costs associated with tobacco and sugary drink consumption.

Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis or benefit costs analysis, is a systematic approach to estimating the strengths and weaknesses of alternatives used to determine options which provide the best approach to achieving benefits while preserving savings. A CBA may be used to compare completed or potential courses of actions, or to estimate the value against the cost of a decision, project, or policy. It is commonly used in commercial transactions, business or policy decisions, and project investments.

Variable universal life insurance is a type of life insurance that builds a cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in separate accounts whose values vary—they vary because they are invested in stock and/or bond markets. The 'universal' component in the name refers to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the Internal Revenue Code for life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy.

In economics, marginal concepts are associated with a specific change 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 thereof.

Pricing strategies strategies related to price when selling products or services

A business can use a variety of pricing strategies when selling a product or service. The price can be set to maximize profitability for each unit sold or from the market overall. It can be used to defend an existing market from new entrants, to increase market share within a market or to enter a new market.

For the application of engineering economics in the practice of civil engineering see Engineering economics.

Economics of the arts and literature branch of economics that studies the economics of creation, distribution, and the consumption of cultural products

Economics of the arts and literature or cultural economics is a branch of economics that studies the economics of creation, distribution, and the consumption of works of art, literature and similar creative and/or cultural products. For a long time, the concept of the "arts" were confined to visual arts and performing arts in the Anglo-Saxon tradition. Usage has widened since the beginning of the 1980s with the study of cultural industry and the economy of cultural institutions. The field is coded as JEL: Z11 in the Journal of Economic Literature classification system used for article searches.

In economics, profit in the accounting sense of the excess of revenue over cost is the sum of two components: normal profit and economic profit. All understanding of profit should be broken down into three aspects: the size of profit, the portion of the total income, and the rate of profit. Normal profit is the profit that is necessary to just cover the opportunity costs of an owner-manager or of a firm's investors. In the absence of this profit, these parties would withdraw their time and funds from the firm and use them to better advantage elsewhere. In contrast, economic profit, sometimes called excess profit, is profit in excess of what is required to cover the opportunity costs.

Car costs

The car internal costs are all the costs consumers pay to own and operate a car. Normally these expenditures are divided by fixed or standing costs and variable or running costs. Fixed costs are those ones which do not depend on the distance traveled by the vehicle and which the owner must pay to keep the vehicle ready for use on the road, like insurance or road taxes. Variable or running costs are those that depend on the use of the car, like fuel or tolls.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

  1. Kenton, Will (June 25, 2019). "Opportunity Cost". Investopedia. Retrieved 2010-09-18.
  2. Stevenson, Angus; Lindberg, Christine A. (2011). "opportunity cost". New Oxford American Dictionary. Oxford University Press. ISBN   978-0-19-539288-3.
  3. Buchanan, James M. (2017). "Opportunity Cost". The New Palgrave Dictionary of Economics. London: Palgrave Macmillan UK. pp. 1–5. doi:10.1057/978-1-349-95121-5_1433-2. ISBN   978-1-349-95121-5.
  4. "Opportunity Cost". Economics A–Z. The Economist. Retrieved 2010-09-18.
  5. Green, David L. (January 1894). "Pain-Cost and Opportunity-Cost". The Quarterly Journal of Economics. 8 (2): 218–229. doi:10.2307/1883711. ISSN   0033-5533. JSTOR   1883711.
  6. "AP Economics Review: Cost, Revenue, and Profit". ReviewEcon.com. Retrieved 2016-10-14.
  7. Gittins, Ross (19 April 2014). "At the coal face economists are struggling to measure up". The Sydney Morning Herald. Retrieved 23 April 2014.