The opportunity cost of anything is the return that can be obtained from the next best alternative use. 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. The opportunity costs are the ‘costs of sacrificed alternatives.’
Whenever the manager takes a decision he chooses one course of action, sacrificing the other alternative courses. We can therefore evaluate the one, which is chosen in terms of the other (next best) alternative that is sacrificed. A machine can produce either X or Y. The opportunity cost of producing a given quantity of X is the quantity of Y which it would have produced.
The opportunity cost of holding Rs.1000 as cash in hand for one year is the 10% rate of interest, which would have been earned had it been invested in the form of fixed deposits in the bank.
- all decisions which involve choice must involve opportunity cost calculation,
- the opportunity cost may be either real or monetary, either implicit or explicit, either non-quantifiable or quantifiable.
Opportunity costs’ relevance is not limited to individual decisions. Opportunity costs are also relevant to government’s decisions, which affect everyone in society. A common example is the guns-versus-butter debate. The resources that a society has are limited; therefore its decisions to use those resources to have more guns (more weapons) means that it must have less butter (fewer consumer goods). Thus when society decides to spend 100 crore on developing a defence system, the opportunity cost of that decision is 100 crores not spent on fighting drugs, helping the homeless, or paying off some of the national debt.
Figure 2.1: Production Possibility Curve
For the country as a whole, the production possibility reflects opportunity costs. Figure 2.1 shows the Production Possibility Curve (PPC) reflecting the different combinations of goods, which an economy can produce, given its state of technology and total resources. It illustrates the menu of choices open to the economy. Let us take the example that the economy can produce only two goods, butter and guns. The economy can produce only guns, only butter or a combination of the two, illustrating the trade offs or choice inherent in such a decision. The opportunity cost of choosing guns over butter increases as the production of guns is increased. The reason is that some resources are relatively better suited to producing guns. The quantity of butter, which has to be sacrificed to produce an additional unit of guns, is called the opportunity cost of guns (in terms of butter). Due to the increasing opportunity cost of guns, the PPC curve will be concave to the origin. Increasing opportunity cost of guns means that to produce each additional unit of guns, more and more units of butter have to be sacrificed. The basis for increasing opportunity costs is the following assumptions:
i) Some factors of production are more efficient in the production of butter and some more efficient in production of guns. This property of factors is called specificity. Thus specificity of factors of production causes increasing opportunity costs.
ii) The production of the goods requires more of one factor than the other. For example, the production of guns may require more capital than that of butter. Hence, as more and more of capital is used in the manufacture of guns, the opportunity cost of guns is likely to increase.
Let us assume that an economy is at point A. Starting from A, increase in the production of 1 unit of guns requires that AB units of butter be given up. The production of another unit of guns requires that additional BC units of butter be given up. Similarly increasing another unit of guns requires that CD of butter be given up, and so on. Since CD>BC>AB, and so on, it means that for every additional unit of guns more and more units of butter will have to be sacrificed, or in other words, the opportunity cost keeps on increasing.
The opportunity cost of the first few units of guns would initially be low and those resources, which are more efficient in the production of guns move from, butter production to gun production. As more and more units of guns are produced, however, it becomes necessary to move into gun production, even for those factors, which are more efficient in the production of butter. As this happens, the opportunity cost of guns gets larger and larger. Thus, due to increasing opportunity costs the PPC is concave.
If the PPC curve were to be a straight line, the opportunity cost of guns would always be constant. This would mean equal (and not increasing) amounts of butter would have to be forgone to produce an additional unit of guns. The assumption of constant opportunity costs is very unrealistic. It implies that all the factors of production are equally efficient either in the production of butter or in the production of guns.
For many of the choice society make opportunity costs tend to increase as we choose more and more of an item. Such a phenomenon about choice is so common, in fact, that it has acquired a name: the principle of increasing marginal opportunity cost. This principle states that in order to get more of something, one must give up ever-increasing quantities of something else. In other words, initially the opportunity costs of an activity are low, but they increase the more we concentrate on that activity.