Question

What is meant by opportunity cost? Illustrate by giving an example.

Short answer

Opportunity cost is the value of the next best alternative that is forgone when making a choice. It represents the cost of choosing one option over another, considering what is given up in terms of other opportunities. For example, if you choose to go to the cinema instead of studying, the opportunity cost is the potential improvement in your exam grade that you give up. In a business scenario, if a company chooses to produce Product A instead of Product B, the opportunity cost is the potential profit from producing Product B. Understanding opportunity cost helps individuals and businesses make informed decisions by evaluating the benefits and costs of each decision.

Step-by-step solution

Understanding Opportunity Cost

Opportunity cost is an economic concept that refers to the value of the next best alternative that must be forgone when a choice is made. In other words, it is the cost of choosing one option over another, taking into consideration what you give up in terms of other opportunities when you make that choice.

Provide an Everyday Example

Let us imagine a scenario where you have two options on a Saturday evening: you can either go to the cinema to watch a movie or stay at home and study for an upcoming exam. If you choose to go to the cinema, the opportunity cost is the potential improvement in your exam grade that you give up by not studying. Conversely, if you decide to study, the opportunity cost is the enjoyment and relaxation you give up by not going to the cinema. Your choice will depend on which option you value more, and which cost you are willing to accept.

Provide a Business Example

Now, consider a business that manufactures two products: Product A and Product B. Due to limited resources, the company can only produce one product at a time. If the company decides to produce Product A, the opportunity cost is the potential profit it could have earned from producing Product B. If the company decides to produce Product B, the opportunity cost is the potential profit it could have earned from producing Product A. The company will need to determine which product has the highest potential profit, and therefore, the lowest opportunity cost. In conclusion, opportunity cost represents the value of the next best alternative that is sacrificed when making a choice. It helps individuals and businesses make informed decisions by considering the benefits of different options and the costs associated with each decision.

Key concepts

Understanding Economic Concepts

The realm of economics is filled with terms and principles that guide individuals and businesses in their decision-making processes. Understanding these core ideas is pivotal.

What is Economic Concept?

At the heart of economics is the 'economic concept', a term encompassing the theoretical constructs that underpin the study of how societies use resources to produce valuable commodities and distribute them among different people. Within this broad definition are numerous principles, such as scarcity, supply and demand, and opportunity cost—the focus of our textbook exercise.

The 'opportunity cost' is a prime example of an economic concept. It represents the foregone benefits that could have been enjoyed if the next best alternative had been chosen. This notion helps to underline the scarcity of resources and the need to allocate them judiciously, ensuring that the options we forsake in our decisions are worth the benefits of the choices we make.

Decision Making in Economics

Every choice has a price, and understanding this is fundamental when it comes to economic decision-making.

How Does Opportunity Cost Affect Decisions?

Decision making in economics always involves considering opportunity costs. When an individual, business, or government faces multiple options, they evaluate the benefits and drawbacks associated with each potential choice. This evaluation is not solely about the immediate tangible costs, but more importantly, about the implicit costs—which include the benefits that will not be realized because an alternative path was not taken.

For instance, when a student opts to work part-time instead of studying full-time, the opportunity cost they must consider is not just the income they earn from working, but also the potential long-term earnings they might forego by not completing their education sooner. It's this balancing act between what is immediately tangible and the potential future rewards that lies at the core of economics' perspective on decision making.

The Role of Cost-Benefit Analysis

When faced with decisions, we often use cost-benefit analysis as a systematic approach to weigh the pros and cons.

Applying Cost-Benefit Analysis

Cost-benefit analysis is a method used to evaluate the total expected benefits compared to the total expected costs of one or more actions in order to choose the best or most profitable option. It boils down complex decisions into a quantifiable comparison of their potential costs and benefits.

In the context of opportunity cost, this analysis is essential—it helps determine the true value of the foregone opportunities. For instance, our business example from the textbook exercise used cost-benefit analysis to decide between manufacturing Product A or Product B, weighing the potential profits against each other.

A thorough cost-benefit analysis will include all direct and indirect costs, as well as tangible and intangible benefits. For students and businesses alike, mastering this economic tool can be the key to making well-rounded and forward-thinking decisions.