THE OPPORTUNITY COST PRINCIPLE

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 Frdric
Bastiat in his essay "What Is Seen and What Is Not Seen".

Definition
Opportunity cost is opportunity lost. We lose opportunity because of the lack of
resources.
Resources, both natural and man-made are scarce. They are scarce in relation
to demand for them to satisfy the ever growing human needs. Resources, though
scarce, have alternate uses.
The scarcity and alternative uses of the resources give rise to the concept of
opportunity cost. Resources available to a business unit- be it an individual firm,
a joint stock corporation or a multinational- are limited. But the limited resources
available to a firm can be put to alternative uses.

New Oxford American Dictionary defines it as "the loss of potential gain from
other alternatives when one alternative is chosen". 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.

For example, suppose a firm has 100 million rupees at its disposal and the firm
finds three risk-free alternative uses of the fund available to it:

i) To expand the size of the firm

ii) To set up a new production unit in another city
iii) To buy shares in another firm.
Thus, the opportunity cost of availing an opportunity is the foregone income
expected from the second best opportunity of using the resources.
-- The difference between actual earning and its opportunity cost is called
economic gain or economic profit. The concept of opportunity cost assumes a
great significance where economic gain is neither insignificant nor very large
because then it requires a careful evaluation of the two options.

-- The applicability of the opportunity cost concept is not limited to decisions

involving finances.
The concept can be applied to all other kinds of resources involved in business
decisions, especially where there are at least two alternative options involving
costs and benefits.
For example, suppose a firm has to take a decision on whether to fire an efficient
labour officer in settlement of a dispute with the labour union or to allow the
matter to be taken to the labour court. If the firm decides to fire the labour officer,
then the loss of an efficient, reliable labour officer is the opportunity cost of
buying peace with the labour union. If the firm decides to retain the labour officer,
come whatever may, then the cost of prolonged litigation, the cost arising out of a
possible labour strike and the consequent reduction in output are the opportunity
costs of retaining the labour officer.

-- 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.

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.

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 .

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.

Examples of Opportunity Costs

One way to demonstrate the concept of opportunity costs is through an

example of investment capital. A private investor purchases $10,000 in a
certain security, such as shares in a corporation, and after one year the
investment has appreciated in value to $10,500. The investor's return is 5
percent. The investor considers other ways the $10,000 could have been
invested, and discovers a bank certificate with an annual yield of 6 percent
and a government bond that carries an annual yield of 7.5 percent. After a
year, the bank certificate would have appreciated in value to $10,600, and
the government bond would have appreciated to $10,750. The opportunity
cost of purchasing shares is $100 relative to the bank certificate, and $250
relative to the government bond. The investor's decision to purchase shares
with a 5 percent return comes at the cost of a lost opportunity to earn 6 or
7.5 percent.

Expressed in terms of time, consider a commuter who chooses to drive to

work, rather than using public transportation. Because of heavy traffic and a
lack of parking, it takes the commuter 90 minutes to get to work. If the same
commute on public transportation would have taken only 40 minutes, the
opportunity cost of driving would be 50 minutes. The commuter might
naturally have chosen driving over public transportation because she had a
use for the car after work or because she could not have anticipated traffic
delays in driving. Experience can create a basis for future decisions, and the
commuter may be less inclined to drive next time, knowing the
consequences of traffic congestion.

In another example, a small business owns the building in which it operates,

and thus pays no rent for office space. But this does not mean that the
company's cost for office space is zero, even though an accountant might
treat it that way. Instead, the small business owner must consider the
opportunity cost associated with reserving the building for its current use.
Perhaps the building could have been rented out to another company, with

the business itself relocated to a location with a higher level of customer

traffic. The foregone money from these alternative uses of the property is an
opportunity cost of using the office space, and thus should be considered in
calculations of the small business's expenses.