In microeconomic theory, opportunity cost, or alternative cost, is the loss of potential gain from other alternatives when one particular alternative is chosen over the others. In simple terms, opportunity cost is the loss of the benefit that could have been enjoyed had a given choice not been made.
As a representation of the relationship between scarcity and choice, the objective of opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated costs of a decision, both explicit and implicit. Opportunity cost also includes the utility or economic benefit an individual lost, it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income.
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Regardless of the time of occurrence of an activity, if scarcity was non-existent then all demands of a person are satiated. It’s only through scarcity that choice becomes essential which results in ultimately making a selection and/or decision.
Sacrifice is a given measurement in opportunity cost of which the decision maker forgoes the opportunity of the next best alternative. In other words, to disregard the equivalent utility of the best alternative choice to gain the utility of the best perceived option. If there were decisions to be made that require no sacrifice then these would be cost free decisions with zero opportunity cost.
Types of opportunity costs [ edit ]
Explicit costs [ edit ]
Explicit costs are the direct cost of an action, executed either through a cash transaction or a physical transfer of resources. In other words, explicit opportunity costs are the out-of-pocket costs of a firm. With this said, these particular costs can easily be identified under the expenses of a firm's income statement to represent all the cash outflows of a firm.
- Land and infrastructure costs
- Operation and maintenance costs - wages, rent, overhead, materials
Scenarios are as follows:
- If a person leaves work for an hour and spends $200 on office supplies, then the explicit costs for the individual equates to the total expenses for the office supplies of $200.
- If a printer of a company malfunctions, then the explicit costs for the company equates to the total amount to be paid to the repair technician.
Implicit costs [ edit ]
Implicit costs (also referred to as Implied, Imputed or Notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes. These costs are often hidden to the naked eye and aren’t made known. Unlike explicit costs, implicit opportunity costs are normally corresponding to intangibles. Hence, they cannot be clearly identified, defined or reported. In terms of factors of production, implicit opportunity costs allow for depreciation of goods, materials and equipment that ensure the operations of a company.
- Human labour
Scenarios are as follows:
- If a person leaves work for an hour to spend $200 on office supplies, and has an hourly rate of $25, then the implicit costs for the individual equates to the $25 that he/she could have earned instead.
- If a printer of a company malfunctions, the implicit cost equates to the total lost production time due to the machine breaking down.
Excluded from opportunity cost [ edit ]
Sunk costs [ edit ]
Sunk costs (also referred to as historical costs) are costs that have been previously sustained and cannot be recovered. Since sunk costs are costs that have been incurred, they remain unchanged by both present and future action. Decision makers who recognise the insignificance of sunk costs then understand that the "consequences of choices cannot influence choice itself".
A scenario is given below:
A company used $5,000 for marketing and advertising on its music streaming service to increase exposure to target market and potential consumers. In the end, the campaign proved unsuccessful. The sunk cost for the company equates to the $5,000 that was spent on the market and advertising means. This expense is to be ignored by the company in its future decisions, and highlights that no additional investment should be made.
See also [ edit ]
- Best alternative to a negotiated agreement
- Budget constraint
- Economic value added
- Fear of missing out
- Opportunity cost of capital
- Parable of the broken window
- Production-possibility frontier
- Reduced cost aka 'opportunity cost' in linear programming
- There ain't no such thing as a free lunch
- Time management
- You can't have your cake and eat it
References [ edit ]
- Stevenson, Angus; Lindberg, Christine A. (2011). "opportunity cost". Oxford University Press. ISBN 978-0-19-539288-3.
- Buchanan, James M. (1991). "Opportunity Cost". The World of Economics: 520–525. doi:10.1007/978-1-349-21315-3_69 – via SpringerLink.
- "Economics A-Z terms beginning with O". The Economist. Retrieved November 1, 2020.
- Hutchison, Emma (2017). Principles of Microeconomics. University of Victoria.
- Parkin, Michael (2016). "Opportunity Cost: A reexamination". The Journal of Economic Education. 47 (1): 12–22 – via Taylor & Francis Online.
- "(PDF) A HISTORICAL VIEW OVER THE OPPORTUNITY COST -ACCOUNTING DIMENSION". ResearchGate. Retrieved 2020-11-01.
- Burch, Earl E.; Henry, William (1974). "Opportunity and Incremental Cost: Attempt to Define in Systems Terms: A Comment. The Accounting Review". The Accounting Review. 49: 118–123 – via JSTOR.
- "Explicit and implicit costs and accounting and economic profit". Khan Academy. 2016. Retrieved November 1, 2020.
- "Explicit Costs: Definition and Examples". Indeed. February 5, 2020. Retrieved November 1, 2020.
- Crompton, John L.; Howard, Dennis R. (2013). "Costs: The Rest of the Economic Impact Story" (PDF). Journal of Sport Management. 27 (5): 379–392.
- "Reading: Explicit and Implicit Costs". Lumen Learning. Retrieved November 1, 2020.
- Devine, Kevin; O Clock, Priscilla (March 1995). "The effect on sunk costs and opportunity costs on a subjective capital allocation decision". The Mid-Atlantic Journal of Business. 31 (1): 25–38.
- "Four Examples of Sunk Cost". Indeed. October 6, 2020. Retrieved November 1, 2020.
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