Opportunity Cost

Source: Wikipedia: Opportunity Cost

Opportunity cost
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Opportunity cost is the next-best choice available to someone who has picked between several mutually exclusive choices.[1] It is a key concept in economics. It is a calculating factor used in mixed markets which favour social change in favour of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice."[2] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.

The concept of an opportunity cost was first developed by John Stuart Mill.[4]

* 1 Examples
* 2 Evaluation
* 3 See also
* 4 References
* 5 External links

[edit] Examples

A person who has $15 can either buy a CD or a shirt. If he buys the shirt the opportunity cost is the CD and if he buys the CD the opportunity cost is the shirt. If there are more choices than two, the opportunity cost is still only one item, never all of them.

A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.

A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price (say $12,000) in the future, inheriting an opportunity cost equal to the future price of $12,000 (and not the future price minus the sale price).

An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.

If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.

Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. Of course, if an individual records one program while watching the other, the opportunity cost will be the time that that individual spends watching one program versus the other. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happier children could therefore be a remodeled bathroom.

If Adam can visit Kate in Western Australia for 3 days of a long weekend, or 7 days of a regular week but have to go to the beach while she goes to the office, then "Seeing Kate" on the days when she must work is the opportunity cost of being in Australia at all on work days. This is a more colloquial stretch of an example.
[edit] Evaluation

The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.

Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.

However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.

In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
[edit] See also

* Trade-off
* Cost of capital
* Opportunity cost of capital
* Economic value added
* Marginalism
* Net income
* Parable of the broken window
* Production-possibility frontier
* There Ain't No Such Thing As A Free Lunch
* Time management

[edit] References

1. ^ Investopedia.com: Opportunity Cost [1]
2. ^ James M. Buchanan (1987). "opportunity cost," The New Palgrave: A Dictionary of Economics, v. 3, pp. 718-21.
3. ^ The Economist's definition of Opportunity Cost
4. ^ Stigler, George S., "The Nature and Role of Originality in Scientific Progress." Economica, Vol. XXII (November, 1955)

[edit] External links

* The Opportunity Cost of Economics Education by Robert H. Frank
* Opportunity Cost by Frank

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