Opportunity cost:

Definition:

Opportunity cost of a particular product is the value of the forgone alternative products that resources used in its production, could have produced. In other words, it is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices. 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 as opportunity costs.

Example: We spend time and money going to a movie, we cannot spend that time at home reading a book, and we spend the money on something else. If our next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure we forgo by not reading the book.

Another example: A watchman working in a factory gets a wage of Rs.1000 per month. He will go to another factory only if he gets more than Rs.1000 per month. Thus, Rs.1000 will be transfer earning of this watchman. Therefore, in terms of money opportunity cost is referred to as transfer money.

Relative Price:

Opportunity cost is expressed in relative price that is, the price of one choice relative to the price of another.

For example, if milk costs $4 per gallon and bread costs $2 per loaf, then the relative price of milk is 2 loaves of bread. If a consumer goes to the grocery store with only $4 and buys a gallon of milk with it, then one can say that the opportunity cost of that gallon of milk was 2 loaves of bread (assuming that bread was the next best alternative).

In many cases, the relative price provides better insight into the real cost of a good than does the monetary price.

Applications of Opportunity Cost:

The concept of opportunity cost has a wide range of applications including:

• Consumer choice
• Production possibilities
• Cost of capital
• Time management
• Career choice
• Analysis of comparative advantage

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.

Opportunity costs in production:

Opportunity costs may be assessed in decision-making process of production. For example, 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. These costs are also called outlay costs or absolute costs or actual costs.

Implicit costs: Implicit costs are the opportunity costs that involve only factors of production that a producer already owns. These arise when a firm makes use of its own resources i.e. its own land, own building, own capital etc.

Submitted to: Prof. Gurdeepak Singh

Submitted by: Shaina Dhiman MBA (C)