When a firm uses resources, it bids against alternative users. To be efficient, a resource’s value in use must be at least as much as its value in alternative opportunities. The role played by choice alternatives in cost analysis is formalized by the opportunity cost concept.
There is a famous saying in economics that “there is no such thing as a free lunch”. Even if we are not asked to pay for consuming a good or a service, scarce resources are used up in the production of it and there must be some opportunity cost involved – the next best alternative that might have been produced using those resources.
Opportunity cost is the foregone value associated with the current rather than next-best use of an asset. In other words, cost is determined by the highest-valued opportunity that must be foregone to allow current use. The cost of aluminum used in the manufacture of soft drink containers, for example, is determined by its value in alternative uses. Soft drink bottlers must pay an aluminum price equal to this value, or the aluminum will be used in the production of alternative goods, such as airplanes, building materials, cookware, and so on. Similarly, if a firm owns capital equipment that can be used to produce either product A or product B, the relevant cost of product A includes the profit of the alternative product B that cannot be produced because the equipment is tied up in manufacturing product A.
The opportunity cost concept explains asset use in a wide variety of circumstances. Gold and silver are pliable yet strong precious metals. As such, they make excellent material for dental fillings. However, when speculation drove precious metals prices skyrocketing during the 1970s, plastic and ceramic materials became a common substitute for dental gold and silver. More recently, lower market prices have again allowed widespread dental use of both metals. Still, dental customers must be willing to pay a price for dental gold and silver that is competitive with the price paid by jewelry customers and industrial users.
Typically, the costs of using resources in production involve both out-of-pocket costs, or explicit costs, and other noncash costs, called implicit costs. Explicit costs are also known as out of pocket costs. They involve cash payments and are clearly reflected by the usual accounting process. Implicit costs are also known as book cost and they do not involve cash payments.
Wages, utility expenses, payment for raw materials, interest paid to the holders of the firm’s bonds, and rent on a building is an example of explicit expenses. The implicit costs associated with any decision are much more difficult to compute. These costs do not involve cash expenditures and are therefore often overlooked in decision analysis. Because cash payments are not made for implicit costs, the opportunity cost concept must be used to measure them. The rent that a shop owner could receive on buildings and equipment if they were not used in the business is an implicit cost of the owner’s own retailing activity, as is the salary that an individual could receive by working for someone else instead of operating his or her own establishment.
Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.
Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money.
Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of the city’s decision to build the hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses—but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed.
Applications of Opportunity Cost
- Consumer Choices
- Production Possibilities
- Cost of Capital
- Time Management
- Career Choice
- Analysis of comparative advantage
On a lighter side, you can check this pictorial representation of Opportunity cost on Abstruse Goose. (http://abstrusegoose.com/267)