Definition – Opportunity cost is the next best alternative foregone.
- If we spend that £20 on a textbook, the opportunity cost is the restaurant meal we cannot afford to pay.
- If you decide to spend two hours studying on a Friday night. The opportunity cost is that you cannot have those two hours for leisure.
Importance of opportunity cost
The fundamental problem of economics is the issue of scarcity. Therefore we are concerned with the optimal use and distribution of these scarce resources. Wherever there is scarcity we are forced to make choices. If we have £20, we can spend it on an economic textbook, or we can enjoy a meal in a restaurant. Therefore, many choices involve an opportunity cost – having to make choices between the two.
Production possibility frontier and opportunity cost
A production possibility frontier shows the maximum combination of factors that can be produced.
- Moving from Point A to B will lead to an increase in services (21-27). But, the opportunity cost is that output of goods falls from 22 to 18.
- Therefore, the opportunity cost of increasing consumption of services is the 4 goods foregone.
At point D, the economy is inefficient. We can increase both goods and services without any opportunity cost.
C is currently impossible.
Examples of opportunity cost
The cost of war. If the government spends $870bn on a war, it is $870bn they cannot spend on education, health care or cutting taxes / reducing the budget deficit.
Spending on new roads. If the government build a new road, then that money can’t be used for alternative spending plans, such as education and healthcare.
Tax cuts. If the government offers an income tax cut, the opportunity cost is that government revenue cannot be used to finance some aspect of government spending.
Time. If you have 12 hours at your disposal during the day, you could spend these hours in work or leisure. The opportunity cost of spending all day watching TV is that you are not able to do any study during the day.
Enter the workforce at 16. If you enter the workforce at 16 without qualifications you start earning money straight away. But the opportunity cost is that you lose out on the potential of getting better qualifications and possibly a higher salary in the long-run.
Example of Actual Opportunity Cost
Suppose you buy a new car for £10,000. After three years it has depreciated in value to £3,000. What is the opportunity cost of deciding to keep the car?
- The opportunity cost of keeping the car is the £3,000 you could have got for selling the car. The price you bought it for is not relevant here.
Importance of opportunity cost
- Do you support the repeal of the estate tax if that means you pay tax on inherited money?
- Do you support the repeal of the estate tax if you have to pay a higher rate of VAT?
See this interesting survey which shows people have very different responses when they understand the opportunity cost involved in a tax cut.
Opportunity cost and comparative advantage
The theory of comparative advantage states that countries should specialise in producing goods where they have a lower opportunity cost.
Opportunity cost and a free good
If there is no opportunity cost in consuming a good, we can term it a free good. For example, if you breathe air, it doesn’t reduce the amount available to other people – there is no opportunity cost.