Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the best alternative forgone. It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices.[1] It is a key concept in economics. It has been described as expressing "the basic relationship between scarcity and choice."[2] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, 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 opportunity costs.
The concept of an opportunity cost was first developed by John Stuart Mill.[4]
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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 (e.g. Dynasty). Of course, 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. For the diner, 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 gluttonous 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, the 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 following from exposure to gasoline, however, is low, estimated a few cases per year in the U.S. Thus, the decision to legally require less aromatics has been criticized on the grounds of opportunity cost: the hundreds of millions spent on process redesign could have been spent on other, more fruitful ways of reducing deaths caused by cancer or automobiles.[5] These actions (or strictly, the best one of them) are the opportunity cost of reduction of aromatics in gasoline.
Opportunity costs in production
Opportunity costs may be assessed in decision-making process of production. If the workers on a farm can produce either 1 million pounds of wheat or 2 million pounds of barley, then the opportunity cost of producing 1 pound of wheat is the 2 pounds of barley forgone. 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 production 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, the opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.
Implicit costs
Implicit costs are by contrast, 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.
Evaluation
The consideration of opportunity costs is one of the key differences between the concepts of economic 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) 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.
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 the 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, as use for any one of those purposes would preclude the possibility to implement any of the other. It is also the cost of the forgone products after making a choice.
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 maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
In a 2005 survey at the annual meeting of American Economic Association, 21.6% of professional economists surveyed chose the correct answer to a question on opportunity cost. The researchers later asked a similar but differently phrased question, to which a majority of the economists surveyed gave an incorrect answer. When the researchers posed the original question to a larger group of college students, 7.4% of those who had taken a course in economics answered correctly, compared to 17.2% of those who had never taken one. The researchers, Paul J. Ferraro and Laura O. Taylor of Georgia State University, labeled the results "a dismal performance from the dismal science."[6]
See also
- Trade-off
- Cost of capital
- Opportunity cost of capital
- Economic value added
- Marginalism
- Net income
- Parable of the broken window
- Production-possibility frontier
- There Ain't No Such Thing As A Free Lunch
- Time management
References
- ^ "Opportunity Cost". Investopedia.com:. http://www.investopedia.com/terms/o/opportunitycost.asp. Retrieved 2010-09-18.
- ^ James M. Buchanan (2008). "Opportunity cost". Second Edition. The New Palgrave Dictionary of Economics Online. http://www.dictionaryofeconomics.com/search_results?q=opportunity+cost&edition=current&button_search=GO. Retrieved 2010-09-18.
- ^ "Opportunity Cost". Economics A-Z. The Economist. http://www.economist.com/research/Economics/alphabetic.cfm?letter=O#opportunitycost. Retrieved 2010-09-18.
- ^ George Stigler (November 1955). "The Nature and Role of Originality in Scientific Progress". Economica XXII.
- ^ Harold A. Wittcoff, Bryan G. Reuben, Jeffery S. Plotkin. Industrial Organic Chemicals. Wiley 2004.
- ^ Robert H Frank (2005-09-01). "The Opportunity Cost of Economics Education". New York Times. http://www.nytimes.com/2005/09/01/business/01scene.html?_r=2. Retrieved 201009-18.
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