Question

Opportunity cost is the price that a firm must pay to a factor to prevent it from moving to the next best alternative use of the factor.

Short answer

Answer: In the context of a firm, opportunity cost represents the value of the next best alternative forgone when allocating resources towards one particular use, instead of the next best alternative use. To calculate the opportunity cost of a factor, one should find the difference between the profit generated from its current use and the profit that would have been generated from the next best alternative use.

Step-by-step solution

Understand the Concept of Opportunity Cost

Opportunity cost is defined as the value of the next best alternative that is forgone when making a decision. It represents the benefits we miss out when choosing an option over another. In the context of a firm, opportunity cost is the cost of allocating resources towards one particular use, instead of the next best alternative use.

Define the Next Best Alternative Use of a Factor

When we talk about the next best alternative use of a factor, we mean the most profitable or valuable option the firm has to employ the factor, given that it can't be used for its current purpose. For example, if a firm is using a machine to make product A, the factor's next best alternative use could be making product B, which might be less profitable but still valuable.

Create an Example Scenario to Illustrate Opportunity Cost

Let's consider a real-life example to demonstrate the concept of opportunity cost. Suppose a firm is using a worker to produce Product X, which generates a profit of \(100 per hour. The worker's next best alternative use is producing Product Y, which would generate a profit of \)80 per hour.

Calculate Opportunity Cost of the Factor

To calculate the opportunity cost of the worker, we need to find the difference between the profit generated from the current use (Product X) and the profit that would have been generated from the next best alternative use (Product Y). In this case, the opportunity cost is: Opportunity Cost = Profit from Current Use (Product X) - Profit from Next Best Alternative Use (Product Y) Opportunity Cost = \(100 - \)80 Opportunity Cost = $20 This means that the firm must pay the worker at least \(20 per hour to prevent them from moving to the next best alternative use of their labor (producing Product Y). This \)20 represents the opportunity cost of the worker's labor for the firm. By understanding and calculating the opportunity cost of a factor, firms can make better-informed decisions about resource allocation and ensure they are maximizing their potential profits.