What is the Opportunity Cost of a Decision?
Opportunity cost (also called foregone benefit) is a term from microeconomics theory, which represents the theoretical loss in value (tangible and/or intangible) arising when an organization or individual chooses to undertake one activity from two or more alternatives and is the amount of benefit that could be derived from the most profitable alternative among the ones not undertaken.
The concept of loss due to not choosing a particular option arises fairly often in the real world, as firms are always making decisions and forgoing alternative choices, thereby always incurring these costs and having to account for them in their calculations.
A quick example to kick things off from the perspective of an individual would be when you are currently dedicating your time to read this article, as opposed to the next best alternative which could be, for example, watching something interesting on television. Therefore, your choice to read this article results in you missing out on watching your show on television.
However, this concept can get more complicated and there are a variety of factors that need to be taken into account anytime the cost is calculated, as we will now explore.
Opportunity costs for businesses (Microeconomics theory)
Asprimarily deals with how decision-makers allocate resources across various alternatives by analyzing costs and benefits of each, this concept can be applied in all walks of life that involve decision making. However, it is primarily applied as part of microeconomics to the decision-making process in businesses and how they allocate resources between various available alternatives.
Microeconomics theory classifies resources into 2 broad categorizations;
- Free goods, and
- Economic goods
Free goods - What are they?
Free goods are goods available in unlimited supply and are essentially resources that are never run out. Examples of free goods are heat and light from the sun or water from the oceans on Earth. Due to the nature of their unlimited supply, allocating them in any way does not result in any opportunity cost, as we will forever have access to them. Therefore, free goods have no such cost and do not affect the decision-making process in any way.
Economic goods - What are They?
Economics goods, on the other hand, make up the majority of the goods purchased, sold, utilized, and allocated within the global economy. As you would've guessed already, economic goods exist in limited supply, therefore making them scarce resources (eg: oil, minerals, metals, etc.)
As these resources are naturally limited in supply, not using them in the best possible way leads to a loss in gain that can be generated from them. To illustrate, let's look at the case of gasoline which is a limited resource. Let's assume a business can choose to provide each employee with fuel expenses to use their own cars on their commute to work or have them use a means of collective transport. As can be easily deduced, from the point of the overall economy, it is almost always better to have them use a means of collective transport as it leads to efficiencies of scale leading to better allocation of gasoline (which is an economic good and hence limited in supply), thereby leading to lower costs. However, from the point of view of the business, it can be argued that time is more important than gasoline, and hence it makes sense that the top-performing employees have their own cars. This is a dilemma where the concept of this cost comes in handy. If the employees in question provide more value on the time saved by having their own cars than the cost of gasoline, it makes sense to have them use their own cars and vice versa. In this case, the alternative benefit of using their own cars is the cost-saving that could have been achieved had they been made to use a collective means of transportation.
As the above example illustrates, it is not always easy to make decisions economically based on the concept of scarcity of resources, as a lot of costs are hidden or unaccounted for. It is in these circumstances that tools like alternative cost improve our decision-making process by providing a benchmark to measure costs and income against. If at any point the benefit from the current use of a resource is less than its alternative-use benefit, we know that it is not being utilized efficiently.
Efficient allocation of economic goods: Real-world example
For example, if a major car manufacturer such as Toyota with lower costs of production as a result of its scaled business is able to produce one car by utilizing 800 kg of steel, then the foregone benefit incurred by Toyota for producing one car would be 800 kg of steel (among other things).
Alternatively, if a small local car manufacturer has not yet achieved the level of Toyota's scaled business, it may have higher costs of production resulting in it utilizing 1,200 kg of steel to produce one car of the exact same quality as that of Toyota's. Therefore, a small manufacturer's alternative benefit of producing one car would be 1,200 kg of steel (among other things).
Seeing as though Toyota has a lower alternative benefit of producing goods, it makes sense for the global economy to allocate its steel resources to Toyota instead of the small manufacturer, as the output would be maximized, and therefore the global economy would incur the lowest possible foregone costs, which represents an efficient allocation of economic resources.
cost of forgone opportunity represented by microeconomics graphs (Production possibility curves)
A Production Possibility Curve (PPC) or Production Possibility Frontier (PPF) is a curve plotted on a graph, from microeconomic theory. Given a specific amount of scarce resources in the economy, the PPC shows us the various combinations of 2 goods we can produce, allowing us to calculate the foregone benefit of producing one good (in terms of the other good).
Let's understand it further with the help of a graph showing the PPC.
Production Possibility Curve explained
The following PPC displays how much of 2 types of goods (basketballs and fidget spinners) an economy can produce given a fixed level of resources.
*Credit to Khanacademy for the PPC.
The curve (blue line) in the graph represents the output using the maximum available resources an economy has to capitalize on and is referred to as the PPC Curve.
Therefore, an economy producing the number of goods represented by any point on the curve (blue line) is considered economically efficient, as it is utilizing all of its resources. For example, the 2 points on the blue line titled "Efficient" represent maximum efficiency achieved by the economy, as it lies on the curve. As we can see from the location of points, the economy can achieve maximum efficiency by producing 3 units of basketballs, and ~7.75 units of fidget spinners, or 6 units of basketballs and 6 units of fidget spinners. Any other point on the PPC (eg: 9 units of basketballs and 0 units of fidget spinners being produced) also represents maximum efficiency.
An economy is unable to produce 2 goods at points outside the PPC, as there simply aren't enough available resources to do so. As the orange point titled "Impossible" tells us, it is impossible for the economy to produce 8 units of basketballs and 7 units of fidget spinners.
PPC questions, try it yourself
The following questions use the graph PPC graph showing the various combinations of basketballs and fidget spinners that an economy can produce.
Calculating opportunity costs from the PPC
Calculating opportunity costs from the PPC is a fairly straightforward process, as we will now explain. Let us take the following PPC for reference (Credit to EconomicsOnline).
The graph above shows 3 points of maximum efficiency (A, B, and C) lying on the PPC, each representing a different type of allocation of resources in producing mobile phones and cameras.
To find the foregone benefit of any good X in terms of the units of Y given up from the PPC, we use the following formula:
Opportunity cost of each unit of Good X = (Y1-Y2) / (X1- X2) units of good Y
Let us now utilize this formula to calculate the foregone costs (in terms of cameras) of producing one unit of mobile phones, and the costs (in terms of mobile phones) of producing one unit of cameras, in reference to the PPC above.
Firstly, let's make a table showing details of the 3 different production combinations represented by points A, B, and C on the PPC above.
Therefore, if a producer is producing 20 cameras and 7 mobile phones, but wants to make one more mobile phone, it can instead produce 10 cameras and 8 mobile phones.
Therefore, the foregone benefit of producing one mobile phone
= (20 - 10) / (8 - 7)
= 10 cameras
This means that for every 1 extra mobile phone the economy produces, it incurs a foregone benefit of 10 cameras.
Helpful resources on calculating the cost due to forgone opporunity
The following resource from Khan Academy covers this concept in-depth and is a great point of reference.
The full article supporting the video can be found here.
Alternative formula to calculate opportunity costs
An alternative formula used to calculate it is:
Opportunity Cost = FO − CO
FO = Return on the best-forgone option
CO = Return on the chosen option
Using The Alternative Formula
Let's say you have the option to invest in a stock, or machinery in your factory. Stock A has a return on investment of 8% for the next year, and investing in machinery allows your business to manufacture more products, therefore returning an expected 5% on your investment. Therefore, by choosing to invest in capital equipment instead of the stock market, your cost would be 8% - 5% (FO - CO), equalling 3 percentage points.
These costs can be often overlooked by businesses and are easy to miss. The following questions can help you catch easily such overlooked costs, as well as account for the factors involved in calculating them.