Opportunity cost is the cost which is not actually incurred, but would have been incurred in the absence of employment of self-owned factors. As expenditure is not currently incurred, this cost is often ignored and not recorded in the books of accounts.
However, management should never ignore it while taking business decisions. In the words of Joel Dean, “In business problems, the massage of opportunity costs is that it is dangerous to confine cost knowledge to what the firm is doing. What the firm is not doing is frequently the critical cost consideration, which it is perilous but easy to ignore.”
The concept of opportunity cost was popularised by the American writers. It occupies a very important place in modern economic analysis. Opportunity cost of any input is the next best alternative use that is sacrificed by its present use.
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It is measured by the value of factors of production used in producing a good, when put to the next best alternative use. In other words, it indicates what a factor could earn in the next best use. Opportunity cost reflects the benefits we give up to select the-most preferred choice.
For example, Meetu sacrifices lunch and takes his girlfriend Charu to the cinema. In this case, the opportunity cost of the cinema is the lunch he did not have.”Similarly, if a farmer decides to grow wheat instead of rice, the opportunity cost of the wheat would be the rice, which he might have grown rather.
Thus, opportunity cost is the cost of foregone alternative. If we produce more of one thing, resources have to be withdrawn from other uses, as these are scarce. In the words of Lipsey, “The opportunity cost of using any factor is what is currently foregone by using it”. Opportunity cost is also the opportunity lost or sacrificed. To quote Watson, “Cost of anything is the value of the alternative or the opportunity that is sacrificed”.
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Implicit cost incurred by a firm is actually the opportunity cost of the factor owned by him. By employing this factor in the firm, the producer loses the opportunity of earning the factor income, had it been employed elsewhere. Thus, the opportunity cost of a factor input is nothing but a potential return from the next best alternative use of that factor.
Opportunity cost is also the minimum price necessary to retain a factor in the current employment. Joan Robinson calls it transfer earning. Since a firm has to pay to owners of factors what they can secure in alternative employment, opportunity cost is also known as alternative cost.
Opportunity cost of a good is not simply any other alternative good that could be produced with the same factors. It is only the most valuable (or next best alternative) good, which the same factors or nearly the same value of factors could produce.
To quote Benham. “The 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”.
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The concept of opportunity cost is highly useful to each and every economic unit. Each cost concept can be expressed in terms of opportunity cost. Every action that we take involves an opportunity cost, as cost of getting something involves losing something else. For a student, the cost of seeing a movie may be the book, whose purchase is foregone.
For the consumer, the opportunity cost of buying a commodity is the price; he pays for it in monetary terms. For the Government, the cost of building a college may be the hospital sacrificed. For the society, the cost of setting up arms factory may be the bread and butter sacrificed. It can be shown on the production possibility curve.
Opportunity concept has wide economic implications. It is important in the context of factors of production. As supply of the factors is limited, a factor can be utilised in one use (or at present) by sacrificing its use for other purpose (in future). It helps us to know, how limited resources get allocated in different branches of production.
Further, it can be used to determine factor price. The concept is especially relevant for an industry which must pay wages which are at least equal to what are being paid in other industries. Otherwise, labour will shift to another industry.
Thus, the opportunity cost concept is useful in short term decisions like sales strategy, inventory management, hiring and firing of labour, etc. It is also applicable in investment planning to make a choice of best alternative after evaluating all available alternatives carefully. A profit oriented firm, must consider opportunity cost besides explicit cost in order to use all the resources most economically.
The concept of opportunity cost has some limitations. It is only applicable to those factors which have alternative uses. Sunk cost has no opportunity cost. Thus, if no sacrifice is involved, then the opportunity cost is zero, even though the actual cost or the acquisition cost or the historical cost (the cost at which the factor was originally acquired or purchased) was substantial.
Further, foregone alternatives are often not clearly ascertainable due to imperfect knowledge of factor owners and imperfections in the market.