Opportunity Cost

Opportunity Cost

opportunity cost

Option B is to reinvest your money back into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good. The law of increasing opportunity cost is the concept that as you continue to increase production of one good, the opportunity cost of producing that next unit increases. This comes about as you reallocate resources to produce one good that was better suited to produce the original good.

Opportunity cost definition

Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively highly paid businesspeople, conservative estimates set the average “price of time” for air travelers at $20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × $20/hour—or, $8 billion per year.

If you choose to marry one person, you give up the opportunity to marry anyone else. Still, one could consider opportunity costs when deciding between two risk profiles.

If you decide to spend money on a vacation and you delay your home’s remodel, then your opportunity cost is the benefit living in a renovated home. For time management, if you decide to spend time working late at the office on an important project, your opportunity cost is the benefit of spending quality family time at home. If you decide to purchase a new piece of equipment, your opportunity cost is the money spent elsewhere. Companies must take both explicit and implicit costs into account when making rational business decisions.

A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss. If you spend your income on video games, you cannot spend it on movies.

If, for example, the (absolute) slope at point BB in the diagram is equal to 2, to produce one more packet of butter, the production of 2 guns must be sacrificed. If at AA, the marginal opportunity cost of butter in terms of guns is equal to 0.25, the sacrifice of one gun could produce four packets of butter, and the opportunity cost of guns in terms of butter is 4. The slope of the production–possibility frontier (PPF) at any given point is called the marginal rate of transformation (MRT). The slope defines the rate at which production of one good can be redirected (by reallocation of productive resources) into production of the other. It is also called the (marginal) “opportunity cost” of a commodity, that is, it is the opportunity cost of X in terms of Y at the margin.

Therefore, the cost is losing more units of the original good to produce one more of the new good. For the sake of simplicity, assume the investment yields a return of 0%, meaning the company gets out exactly what it put in. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The opportunity cost of choosing this option is then 12% rather than the expected 2%. The law of increasing opportunity costs states that as you increase production of one good, the opportunity cost to produce an additional good will increase.

What is opportunity cost give example?

Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%.

Clearly, the opportunity costs of waiting time can be just as substantial as costs involving direct spending. Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that’s desired.

  • If, for example, the (absolute) slope at point BB in the diagram is equal to 2, to produce one more packet of butter, the production of 2 guns must be sacrificed.
  • The marginal rate of transformation can be expressed in terms of either commodity.
  • The marginal opportunity costs of guns in terms of butter is simply the reciprocal of the marginal opportunity cost of butter in terms of guns.

Explicit costs

However, the single biggest cost of greater airline security doesn’t involve money. According to the United States Department of Transportation, more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past.

To understand the law of increasing opportunity costs, let’s first define opportunity costs. Opportunity cost is the cost of what you are giving up to do what you are currently doing. If you can either go to work or go to the beach, and you choose to work, the opportunity cost of working is the value you would have gotten had you gone to the beach.

Opportunity Cost

opportunity cost

Often, they can determine this by looking at the expected rate of return for an investment vehicle. However, businesses must also consider the opportunity cost of each option. It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk-free, to investment in a highly volatile stock can cause a misleading calculation.

From a macroeconomic perspective, the PPF illustrates the production possibilities available to a nation or economy during a given period of time for broad categories of output. It is traditionally used to show the movement between committing all funds to consumption on the y-axis versus investment on the x-axis. However, an economy may achieve productive efficiency without necessarily being allocatively efficient. The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Say that you have option A, to invest in the stock market hoping to generate capital gain returns.

If investment A is risky but has an ROI of 25% while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the opportunity cost of going with option B will be salient. As an investor that has already sunk money into investments, you might find another investment that promises greater returns. The opportunity cost of holding the underperforming asset may rise to where the rational investment option is to sell and invest in the more promising investment. When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return.

It measures how much of good Y is given up for one more unit of good X or vice versa. The shape of a PPF is commonly drawn as concave to the origin to represent increasing opportunity cost with increased output of a good. Thus, MRT increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF.

The marginal rate of transformation can be expressed in terms of either commodity. The marginal opportunity costs of guns in terms of butter is simply the reciprocal of the marginal opportunity cost of butter in terms of guns.

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