Opportunity Cost

Opportunity cost is defined as the value given up by selecting one of a group of mutually exclusive alternatives. The fundamental economic problem is one of scarcity. Humans have virtually unlimited needs and wants for goods and services, but resources or inputs, such as land, labor, and capital, are limited. This combination of unlimited demand and scarce resources compels individuals and societies to make choices. When a choice is made, there is a trade-off and something must be given up. The value of the next best alternative that might have been chosen is called the opportunity cost. All decisions made by individuals and societies have an opportunity cost that may be thought of in monetary or nonmonetary terms. For example, the decision to take a walk means giving up time to read a book and the utility or satisfaction that goes along with reading the book.

The opportunity cost of a decision may exceed the out-of-pocket cost. An example often used to illustrate this point is the cost of a college education. The opportunity cost of attending college includes not only the monetary cost but also the costs associated with the foregone opportunities, such as earnings from full-time employment or the value of time spent training for the Olympics. If out-of-pocket expenses at a private university are $25,000 per year for tuition, fees, and textbooks and foregone earnings equal $18,000 per year, then the total cost of college attendance is $43,000 per year. A student must weigh this cost against the current and future benefits received to ensure that he or she is making the most efficient use of scarce resources.

Opportunity cost differs from accounting cost in that the latter does not include foregone opportunities. The financial statements of a business may show an accounting profit, while the business is sustaining an economic loss if opportunity cost is considered. Assume that a small advertising agency has a total revenue of $500,000 per year and accounting costs of $400,000, for an accounting profit of $100,000. If the [Page 1545]small business owner could earn $150,000 per year working for a large advertising agency, then the total opportunity cost is $550,000, and the business is actually suffering a $50,000 annual loss. If the satisfaction (benefit) of self-employment does not equal at least $50,000 per year, the small business owner should shut down the operation and take the $150,000 position at the large advertising agency.

Business decisions are not always based on allinclusive measures of opportunity cost. An example is a manufacturer who does not consider air and water pollution in the choice to adopt or not adopt a new manufacturing process. In a decision not to adopt a cleaner manufacturing process, the opportunity cost of the decision includes the costs of pollution that must be borne by local citizens. In the case of massive plant layoffs, the opportunity cost of dismissing all or part of a labor force may affect the long-term health of the company in the loss of valuable expertise and knowledge, future retraining costs of new workers, and the effects of unemployment on the local community. Community assistance resources may be strained. Local businesses may be affected when the community has less money to spend on goods and services.

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