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Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen). 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" (as a lost benefit) of the forgone 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 forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

History

The term was coined in 1914 by Austrian economist Friedrich von Wieser in his book "Theorie der gesellschaftlichen Wirtschaft". It was first described in 1848 by French classical economist Frédéric Bastiat in his essay "What Is Seen and What Is Not Seen".

Opportunity costs in consumption

Opportunity cost is expressed may be terms of anything which is of value. For example, an individual might decide to use a period of vacation time for travel rather than to do household repairs. The opportunity cost of the trip could be said to be the foregone home renovation.

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 forgone (assuming the production possibilities frontier is linear). 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, 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 in 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 monetary units or being able to produce one good over another. The opportunity cost can also be unknown, or spawn a series of infinite sub opportunity costs. For instance, an individual could choose not to ask a girl out on a date, in an attempt to make her more interested by playing hard to get, but the opportunity cost could be that they get completely ignored, which could lead to other opportunity costs.

Evaluation

Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other – it is the value of the next best use. 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.

Criticism

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, when one investment is assumed to be as good as any, opportunity cost is a less useful concept.

See also

• Budget constraint
• Economic value added
• Opportunity cost of capital
• Parable of the broken window
• Production-possibility frontier
• There Ain't No Such Thing As A Free Lunch
• Time management
• Trade-off

References

1. "Opportunity Cost". Investopedia. Retrieved 2010-09-18.
2. James M. Buchanan (2008). "Opportunity cost". The New Palgrave Dictionary of Economics Online (Second ed.). Retrieved 2010-09-18.
3. "Opportunity Cost". Economics A-Z. The Economist. Retrieved 2010-09-18.
4. Friedrich von Wieser (1927). A. Ford Hinrichs (translator) (ed.). Social Economics (PDF). New York: Adelphi. Retrieved 2011-10-07. {{cite book}}: |editor= has generic name (help)
   • Friedrich von Wieser (1914). Theorie der gesellschaftlichen Wirtschaft (in German). Original publication. {{cite book}}: Unknown parameter |month= ignored (help); Unknown parameter |trans_title= ignored (|trans-title= suggested) (help)CS1 maint: postscript (link)

External links

• The Opportunity Cost of Economics Education by Robert H. Frank
• Opportunity Cost Example & Analysis

• Microeconomics
• Costs
• Economics terminology
• Time-based economics