In this article, we will discuss a topic that is found in most economic topics. It will serve as an important base. In addition, this topic also plays a part in our every day lives. It has major influence on how we make decisions. The topic that we will cover today is opportunity cost. First, we will understand what opportunity cost is. Then we will look at one example of how opportunity cost works in the world. This will be done with the help of production possibility curves. Finally, we will end our discussion with looking at uses of Opportunity cost in day to day life and decisions.
The first question to be answered is, What is opportunity cost? Whenever we have to make a decision, or make a choice, there is something lost. If we choose one thing over the other, we are missing out on something that the other thing would have given us. Something is always lost when a choice is made and something is not selected. A more formal definition can be put in the following way: Opportunity cost is the cost of the foregone alternative. It refers to the benefit a person could have received, but did not, because he ‘chose’ to do something else.
To understand this better, we will look at an example that will explain opportunity cost better.
Let’s say, Karan, a student of Class 8, was given homework and he only has five hours left to do it. He was given homework in two subjects. The first subject was Mathematics and the second subject is General Knowledge. The teacher of Mathematics has given Karan twenty five questions to solve. The General Knowledge teacher has given five questions to solve. If Karan had started his homework when he came home from school, he would have been able to finish questions from both subjects with a lot of time left. But he didn’t and now he can only finish homework of one subject. There is not enough time to do both. So he must make a choice. There are different combinations of how much homework he can solve. These combinations can be shown by the production possibility curve below:
Let us look at all these points individually. At point E, Karan can finish all of his General Knowledge questions. At point C, Karan can finish all Maths questions. B cannot be achieved due to the lack of time. D, on the other hand, is not wanted by Karan because he will not be able to do enough questions. At A, Karan can do some maths questions and some questions from the general knowledge homework.
What are the opportunity costs here? We will only look at opportunity costs at point E, A, and C. Look first at E. At E, Karan can do all five general knowledge questions. But he can’t do any Maths questions. This is because he won’t have the time to do so. The opportunity cost here for him is the Maths questions he didn’t do. Since he chose all general knowledge questions, he will not do any Maths question and will get scolded by his maths teacher. Karan’s opportunity cost because he chose E is the twenty five maths questions he didn’t do.
Now let’s look at point C. This point is the complete opposite of point E. Here, Karan is only doing Mathematics questions. He is leaving the five questions of general questions. The opportunity cost here is the general knowledge questions that he has not done. He will get scolded by the general knowledge teacher. So his opportunity cost here is the five general knowledge questions, he ‘chose’ not to do.
Finally, look at point A. Here, Karan is not able to finish all sums of either subject. Instead he chooses to do fifteen questions of mathematics and 2 questions of general knowledge. Karan thinks that this way, he will be able to keep both teachers happy. At this point, Karan is giving up questions from both subjects. So his opportunity cost will come from both subjects. Karan’s opportunity cost at point A is 10 mathematics question and 1 question of general knowledge.
This is basically what opportunity cost is. When you give up something to do something else, there is opportunity cost. Opportunity cost is applied in many decisions in Economics. When a firm wants to produce something, it must choose between different goods it can produce. If a company wants to invest in something, it has many choices in which it can invest. Every time it choose an investment, it will have some opportunity cost. This is why every time a choice is made, it is tried to keep opportunity cost as little as possible. When it is as low as possible, the benefit from the making the choice is extremely high. This is what is commonly used in Economics to make decisions and this will be seen as further economic analysis is done.