Opportunity cost Principle
Opportunity costs are cash outflows prevented by taking one course of action instead of another. They include returns, which the entrepreneur could have earned in alternative use of his services and capital.
The concept of opportunity cost occupies a very important place in modern economic analysis. The opportunity costs or alternative costs are the return from the second best use of the firm’s resources which the firm forgoes in order to avail itself of the return from the best use of the resources. To take an example, a farmer who is producing wheat can also produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money. Two points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best alternative foregone. Secondly, in the above definition is the addition of the qualification or by an equivalent group of factors costing the same amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to produce a good the producer has to employ various factors of production and have to pay them sufficient prices to get their services. These factors have alternative uses.
The factor must be paid at least the price they are able to obtain in the alternative uses.
Suppose a businessman can buy either a washing machine or a press machine with his limited resources and suppose that he can earn annually Rs. 40,000 and 60,000 respectively from the two alternatives. A rational businessman will certainly buy a press machine that gives him a higher return. But, in the process of earning Rs. 60,000 he has foregone the opportunity to earn Rs. 40,000 annually from the washing machine.
Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between actual and opportunity costs is called economic rent or economic rent or economic profit. For example, economic profit from press machine in the above case is Rs.
60,000 –Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational to invest resources in press machine.
Opportunity cost principle is related and applied to scarce resource. When there are alternative uses of scarce resource, one should know which best alternative is and which is not. We should know what gain by best alternative is and what loss by left alternative is.
Devenport. an American Economist explains the concept of opportunity cost with reference to an example. Suppose a girl had two kinds of fruits- one pear and one peach, and if a bad boy is after her to seize the fruits, then the best way for the girl is to drop one fruit and run with the other, so that, she can at least save one fruit, at the cost of the other. When the girl so drops by the way – side one fruit and runs with the other, then the opportunity cost of the fruit she saves is the foregone alternative of the fruit she lost. This is the opportunity cost theory.
The concept of opportunity cost plays an important role in managerial decisions. This concept helps in selecting the best possible alternative from among various alternatives available to solve a particular problem. This concept helps in the best allocation of available resources.
The opportunity cost of any action is simply the next best alternative to that action – or put more simply, “What you would have done if you didn’t make the choice that you did”.
The income or benefit foregone as the result of carrying out particular decision, when resources are limited or when mutually exclusive projects are involved.
— In the words of Left witch, “Opportunity cost of a particular product is the value of the foregone alternative products that resources used in its production, could have produced.”
Opportunity cost is not what you choose when you make a choice —it is what you did not choose in making a choice. Opportunity cost is the value of the forgone alternative — what you gave up when you got something.
Example 1: If a person is having cash in hand Rs. 100000/-, he may think of two alternatives to increase cash.
Option 1: Investing in bank. We will get returns amount 10000/-
Option2: Investing in business. We get returns amount 17000/-
Generally we chose the option 2 because we will get more returns than the option 1. Here the option 1 is the opportunity cost, that what we have not chosen.
Example 2: I have a number of alternatives of how to spend my Friday night: I can go to the movies; I can stay home and watch the baseball game on TV, or go out for coffee with friends. If I choose to go to the movies, my opportunity cost of that action is what I would have chosen if I had not gone to the movies – either watching the baseball game or going out for coffee with friends. Note that an opportunity cost only considers the next best alternative to an action, not the entire set of alternatives.
The opportunity cost of a decision is based on what must be given up (the next best alternative) as a result of the decision. Any decision that involves a choice between two or more options has an opportunity cost.