The opportunity cost of a decision means the sacrifice of alternatives required by that decision. The concept of opportunity cost can be best understood with the help of a few illustrations, which are as follows:
- The opportunity cost of the funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures.
- The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment.
- The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products.
- The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.
- If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.
- If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py.
- The opportunity cost of holding 100 Dollars as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil.
For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under: “The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.” Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to national fund for buying armor has cost the nation of losing an opportunity of buying more butter. Similarly, a continued diversion of funds towards defense spending, amounts to a heavy tax on alternative spending required for growth and development.
The concept of opportunity cost occupies a very important place in modern economic analysis. The opportunity costs or alternative costs are the return from the second best use of the firm’s resources which the firm forgoes in order to avail itself of the return from the best use of the resources. To take an example, a farmer who is producing wheat can also produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money. Two points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best alternative foregone. Secondly, in the above definition is the addition of the qualification or by an equivalent group of factors costing the same amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to produce a good the producer has to employ various factors of production and have to pay them sufficient prices to get their services. These factors have alternative uses. The factor must be paid atleast the price they are able to obtain in the alternative uses. Suppose a businessman can buy either a washing machine or a press machine with his limited resources and suppose that he can earn annually Rs. 40,000 and 60,000 respectively from the two alternatives. A rational businessman will certainly buy a press machine that gives him a higher return. But, in the process of earning Rs. 60,000 he has foregone the opportunity to earn Rs. 40,000 annually from the washing machine. Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between actual and opportunity costs is called economic rent or economic rent or economic profit. For example, economic profit from press machine in the above case is Rs. 60,000 —Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational to invest resources in press machine.