What is Opportunity Cost Analysis?
Opportunity cost refers to the loss of potential benefits when choosing one alternative over another. It is the tradeoff a person makes, or the potential gains they miss out on, because of their choice. To analyze opportunity cost, we must consider the benefits and tradeoffs of each available option.
Understanding Opportunity Cost
From a production perspective, the opportunity cost of producing any economic good is the economic growth that would be attainable by producing the next-best alternative. In other words, by choosing one good to produce, the tradeoff is the potential economic benefits of producing the other good.
The opportunity cost of producing an amount of a commodity is calculated in terms of the amount of some other commodity that could have been produced in its place. The notion of opportunity cost exists because of a lack or scarcity of resources and because the resources that are used to produce economic goods also have various alternative uses. In other words, the resources you use to produce one good could have been used to produce other types of economic goods. Therefore, when resources are used in the production of a particular economic good, some amount of other commodities has to be foregone.
Opportunity cost analysis is important because it enables producers to make informed decisions about the production process. This concept also evaluates how resources can be used in various alternative ways, which can ultimately minimize the risk of facing any kind of loss. The analysis of opportunity costs enables producers to choose a single option from the various alternatives available.
Applications of Opportunity Cost
The concept of opportunity cost has a wide range of applications. It is fundamental to the basic economic problems, which are what to produce, how to produce, and for whom to produce. It emphasizes the problem of choice. Since resources are scarce, they cannot be used to produce all things simultaneously. The decision to produce a certain kind of good or commodity comprises an opportunity cost corresponding to the commodities that the society has to sacrifice to produce this commodity. With limited resources, we cannot “have the cake and eat it too”. Opportunity cost posits the fact that when society employs resources in a certain way, it is not just deciding to produce these goods, but it is also deciding not to produce some other goods.
Opportunity cost also emphasizes the fact that budget discussions should not be considered in financial or budgetary terms only, but rather it should also be seen in real terms. This phenomenon can be understood with the help of an example: if the government decides that more resources must be devoted to the production of arms, less will be available to produce goods like butter for ordinary people. Thus, the opportunity cost of defense build-up would be a decrease in the production of consumer goods. This is the very famous ‘gun-and-butter’ problem. Similarly, if the government decides to construct more roads by cutting down expenses on the construction of school buildings, then the real cost of constructing more roads for society would be the availability of a lesser number of schools.
The concept of opportunity cost can also be applied to consumers’ behavior. Since an individual cannot satisfy all of their wants due to limited resources in terms of their limited income, they must choose between one thing and another. The satisfaction of one type of want involves sacrificing some other wants i.e., the alternatives have to be foregone to satisfy this want.
For example, if a worker is working in a textile mill earning $1,000 per month, that becomes his or her opportunity cost. Now if an employer in the iron industry wants to employ this worker in their mill, the employer must pay the worker at least $1,000 to employ them. Thus, the minimum price that is necessary to retain a service is its opportunity cost.
Importance of Opportunity Cost Analysis
The analysis of opportunity cost is extremely important in the production process because it gives decision-makers an idea of what kind of cost will be undertaken for the production of a particular economic good. Opportunity cost is one of the factors that should be quantified and considered when a producer makes decisions for the well-being of the business.
It is also very important to calculate the investment that a business owner should make to optimize the benefit of their production process. In economics, opportunity cost analysis can help a producer decide what alternatives they should forego to incur the benefit of profit. Also, it helps in building a production strategy to achieve the optimum level of output.
Since the main constraint for producing goods and services is the scarcity of resources, it is important to assess the choices that the producer or the owner of the business make. The cost of giving up the next best opportunity for the current opportunity is important because the entire production process, and all production decisions, depend on the various costs related to it—namely the explicit cost and implicit cost.
In the diagram below, a firm either produces 40 dollars of wheat or 50 dollars of rice. If it wants to produce one, then it needs to sacrifice the production of the other. Suppose, it produces initially OD amount of rice and OC amount of wheat. If it decides to produce more rice, say OF amount, then it will have to forego the production of wheat in some amount and reduce the production of wheat to OE amount.
Finally, investment decisions also primarily depend upon opportunity cost analysis. Analyzing opportunity cost can give investors a clear-cut idea of what investments they should choose over others.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for:
- BA in Economics
- MA in Economics
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