Opportunity cost is the value of a product forgone to produce or obtain another product.[1] Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement.[2]
Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. It has been described as expressing "the basic relationship between scarcity and choice."[3]. The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[4] 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.
The concept also applies to evolutionary adaptations in an ecological environment.citation needed
Examples
A person who invests $10,000 in a stock denies themselves the interest they could have earned by leaving the $10,000 dollars in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.
An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining their existing asset portfolio incurs the increased risk of failure of their existing assets. The opportunity cost of the decision to acquire a new asset is the cost of failures that occur due to lack of maintenance.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing which might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it were not taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty (and are sometimes called "hidden costs" or "hidden losses", what has been prevented from being produced cannot be seen or known). Even the possibility of inaction is a lost opportunity (in this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns).
It can also apply to time; one might use a limited vacation time to travel to a place of cultural enrichment or to do household improvements. Thus the two-week road trip might preclude repairing or painting one's house that year. To the vast majority of people, time has value.
Evaluation
Opportunity cost needs not be assessed in monetary terms, but rather can be assessed in terms of anything which is of value to the person or persons doing the assessing (or those affected by the outcome). For example, a person who chooses to watch, or to record, a television program cannot watch (or record) any other at the same time. (The rule still applies if the recording device can simultaneously record multiple programs; there is going to be a limit, and if the number of desired programs exceeds the capacity of the recorder, some of them will not be saved, and thus cannot be seen.) In any case, at the time the person chooses to watch a program, either live or on a recording, they cannot watch something else, and if they are not able to record another program showing at the same time, the opportunity to view it is lost (presuming the particular program is not repeated). Or as another example, someone having a video game can choose to watch a program or play the video game on the TV; they can't do both simultaneously. Whichever one they choose is a lost opportunity to experience the other. Or for that matter, a lost opportunity to engage in some other activity entirely (exercising outdoors, or visiting with family or friends, as merely two examples).
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.
Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the 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, or the loss of any of the various other possible uses—but not all of these in aggregate, because the land cannot be used for more than one of these purposes.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.
In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
See also
References
External links
|
