Opportunity cost

Opportunity cost represents the value of what is foregone by making a certain investment or consumption decision. For example, by purchasing a car, you forgo the investment returns of the money you used to purchase the car. From a viewpoint of economic rationality, we would expect that the satisfaction that is derived from the purchase of the car should exceed the value of the investment returns foregone.

Likewise, if a firm makes a capital investment, the firm will expect the investment to generate a greater return than would be available by keeping the money in the bank (the opportunity cost). If the opportunity cost exceeds the return from the investment, then the firm would have been better off had it kept the money in the bank. Note this does not mean that the investment was bad – it may still have been profitable to make the investment. However, there were better choices available – by making the investment, the firm is worse off than it could have been.

Underlying the principle of opportunity cost is the basic element of choice. Economic agents (e.g. individuals, households, firms) choose what to do with their resources, and by making those choices, they forgo other opportunities.

Economic textbooks give the example of a hypothetical economy that has a choice of producing guns or butter (or swords and ploughshares). Its production choices are summarised in the following graph:

The line between the two axes is termed the production frontier and represents the maximum possible production of each of the two commodities given the resources in the economy. All points below the line represent feasible production combinations. However, if production is below the line, then the resources of the economy are not being fully (or efficiently) utilised.

Consider point A on the production frontier. By moving along the production frontier toward point B, the economy is increasing its production of butter, but decreasing its production of guns. In this case, the reduction of output of guns is the opportunity cost of increasing production of butter. Likewise, moving from point B to point A increases the production of guns, but has an opportunity cost of the butter foregone.

This concept of opportunity cost goes right to the heart of most economic thought. The fundamental premise is that a choice is necessary, and that by choosing one option over another, the other option is foregone. To maximise economic welfare, the value of the option we choose should exceed the value of the alternative option.