Opportunity cost refers to loss that occurs due to lost opportunities. It is related to alternate uses of scarce resources. In order words opportunities are forgone due to scarcity of resources. The scarcity and alternative uses of scarce resources give rise to opportunity cost. Further opportunity cost is defined as loss of return from the second best use of resource in order to avail gains from the best possible use. Opportunity cost is also called alternative cost as it is the income expected from the second best alternative use of resources. Unlimited resources may lead to no opportunity cost. People in order to earn maximum gain out of their scarce resource place it into most productive use and have to forego the income expected from the second alternative use.
To understand it better let’s take an example:
Suppose a business has a sum of Rs 5,00,000 which can be used for only two alternative uses; either expansion of size of firm or setting up new production unit. From expansion he expects annual income of Rs 3,00,000 while from setting new unit he expects income of Rs 2,00,000. If the owner is keen of profit he will go for expansion of the business and forego the expected income from new production unit. The opportunity cost of his income from expansion is the expected income from the new production unit. Opportunity cost arises as a result of foregone opportunity. Thus, the resources use for expansion, the best alternative, is the value of return expected from new production unit, the next alternative. Both implicit and explicit costs are taken into account while assessing the alternative costs.
Implicit Cost: It refers to the calculated cost of inputs owned by the business itself and used in its own production unit. Thus, it is a cost that is incurred without any sort of money payments.
Explicit cost: It refers to the cost that business has to incur in acquiring or hiring other factors of production. Thus, it is a cost that is incurred only after money payment.
Whenever opportunity cost is expressed in the terms of money it is referred to as economic cost.
Economic cost: Explicit cost + Implicit cost (including normal profits)
The cost generally referred by any economist is the opportunity cost. Cost of production is confined as opportunity cost for producing commodity with the available factors of production. Thus, opportunity cost is the sum of implicit and explicit cost (Economic cost).
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- Since there is scarcity of resources, all things can’t be produce so there is always a choice. Opportunity cost does not only describe the fact of availing one resource but also forego of another resource.
- Opportunity cost emphasises that problem of national concern should not be looked at financial or budgetary terms instead should be seen in real terms.
- Consumer behaviour is also related with the concept of opportunity cost, as consumer can’t always satisfy his wants due to limited resources and has to forego one thing in order to acquire the other.
- Relative pricing is also related to opportunity cost. Relative pricing is price of one commodity is compared to price of other commodity.
- Opportunity cost also determines factor prices.
The cost that is computed by accountant refers to the explicit cost, which can be seen on the balance sheet. Accounting profit of a firm is equals to total revenue minus explicit cost. While economic cost stands for total revenue less opportunity cost.
Explicit cost is less than opportunity cost as opportunity cost also has implicit cost covered under it. Resultant, accounting profits are more than economic profits.
Thus, opportunity cost is giving on one alternative in order to take the benefit of other, due to limited amount of resources only one alternative choice has to be taken up.
The above explanations should clearly indicate how to compare one option to another when resources are scarce. All decisions in finance and to extend it further, even in life are relative. The biggest hindrance in calculating opportunity cost for each option is time. Business decisions have to be taken quickly within a timeframe due to changing scenarios. If the exact information by prior information is not available, understanding the trend of costs for each option is difficult. In such a scenario, experienced managers and decision making comes in handy.
Project evaluation has to be done on the basis of accurate accounting. Such accounting might not be available for new events or unforeseen circumstances.
Project management techniques are methods of weighing options and calculating opportunity costs. Opportunity costs will also tell you the revenues to be earned form choosing each of the options. This way a cost-benefit analysis can be done effectively.
Opportunity cost is not just a theory for economists but an important measuring parameter for daily life as well. Imagine the limited energy and time you have during a day – you would rather spend it utilising it on a productive activity than waste it away. Similarly, while making business decisions whether large or small, it is important to measure the costs for taking a particular route of plan of action. That is what we have already talked about in detail.
However, you might also sometimes need to make exceptions for certain cases where you need to do things for the goodwill of a client, oblige certain business decisions even if it costs you more or is less profitable. Similarly, in personal life and investing decisions, emotions tend to take over of fear and greed and one might ignore the cold hard results of numbers if we take a particular option. This is part of Behavioural Finance and the study of investing behaviour of people.