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What is Opportunity Cost in Economics? Definition and Example

 

Opportunity Cost

In their day-to-day life, people face many trade-offs, i.e., they have to let go off one option when they choose the other one. Which, option or alternative a person will choose depends apart from his/her preferences upon opportunity cost. In other words, Trade-offs are measured by opportunity costs.
Understanding Opportunity Costs

In simple, terms Opportunity Cost is the value of the next best alternative forgone, i.e., what is the value of that alternative or option which a person had to let go in order to get the other one.

Examples 

 Let’s say a farmer has a piece of land on which he can grow either wheat or rice. For simplicity, we assume that the price of each crop is Rs 20 per kg. With this piece of land, the farmer can produce either 50 kg of wheat or 40 kg of rice. Based on this, we will find what trade-off the farmer faces, and what is the opportunity cost of producing one crop over the other crop. 

If the farmer decides to produce wheat on the entire land, he has to let go the production of rice. So, he faces a trade-off in producing wheat which is the rice whose production he has to forego. We will try to measure this trade-off through the opportunity cost. In our example, if the farmer decides to produce wheat, he has to give up 40 kgs of rice. The value of that 40 kgs of rice is the quantity of rice fortune multiplied by the its price i.e 40 x 20 = Rs 800. So, we say that the opportunity cost of producing wheat is Rs. 800. Similarly, we can find out the opportunity cost of producing rice. The opportunity cost of producing rice, is the next best alternative which he has to let go that is wheat in this case. In this case, the opportunity cost of producing rice is the quantity of wheat forgone multiplied by its price i.e 50 x 20 = Rs 1000.

A trade-off which many students face is when deciding whether to pursue higher education or go for a job. Going for higher education leads to better job prospects in future due to the additional skills and knowledge acquired as compared to students who don’t go for higher education. However, spending an extra year on education means losing the opportunity to work and earn income during that time. Hence, the opportunity cost of going for higher education is the loss of income which could have been earned by working during that period of time. Given this cost and benefit of Higher education, how does a student then decide whether to go for higher education or not. The answer is that it depends upon the opportunity cost. If the student thinks that he will get a higher income after completing his/her higher education as compared what he/she is getting now, the student will go for higher education. However, if the income which he/she will be getting now is higher than what he/she would earn after completing higher education, i.e., the opportunity cost of pursuing higher education is high, the student would not go for an extra year of education. You must have heard of many a successful entrepreneur who dropped out of college, or an actor, athlete, singer not pursuing higher education. This is because their opportunity cost of pursuing higher education is very high and dropping out would be more beneficial.

Therefore, when we have to find the opportunity cost of an alternative, we find the next best alternative and calculate its value.

Importance of Opportunity Cost

Opportunity cost helps us in taking a decision whenever a trade-off arises. In our example above, the value of wheat is Rs 1000 and the Value of Rice is Rs 800. Here, we see that the opportunity cost of producing wheat is the least as the farmer has to give up Rs 800 which is the value of Rice. While the opportunity cost of producing rice is high which is the Rs 1000 the farmer loses if he produces rice. Hence, if the farmer is rational, he would go for the production of wheat instead of rice or in other words, that alternative is chosen whose opportunity cost the lowest.

Opportunity cost need not be measured in monetary terms only. Sometimes, it is measured in real terms. For example, the opportunity cost of studying for an hour is an hour of leisure time which could have been spent with family or sleeping or any other leisure activity. So, the opportunity cost here is not in terms of money but in terms of time.

Key Points

  • Opportunity Cost is the value of the next best alternative forgone.
  • Opportunity cost helps us in taking a decision whenever a trade-off arises.
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