Opportunity cost
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Opportunity cost or economic opportunity loss is the value of the next best alternative foregone as the result of making a decision.[1] Opportunity cost analysis is an important part of a company's decision-making processes but is not treated as an actual cost in any financial statement.[2] The next best thing that a person can engage in is referred to as the opportunity cost of doing the best thing and ignoring the next best thing to be done.
Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. Opportunity cost is a Keynesian term which has come into popular use in the recent decades. It is a calculating factor used in mixed markets which favour social change in favour of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice."[3] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[4] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.
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[edit] Examples
A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.
A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price in the future, inheriting an opportunity cost equal to future price minus sale price.
An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.
Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A woman might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happy children could therefore be a remodelled bathroom.
Another good example of opportunity costs: exclusive relationships. The opportunity cost of being with one person is that you cannot be with others.
[edit] Evaluation
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetory cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.
Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.
However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.
In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.
[edit] Health and environmental policy
Opportunity costs have to be taken into account in cases where a possible risk from a toxic substance is identified. Should the opportunity cost be higher, the risk should be taken.
A health example can be found in Baltic herring, which has been contaminated with dioxin from the environment in excess of European Union limits. The most obvious response would be to ban it, but Finnish officials have decided not to do so. The reason is that the opportunity cost is that the person would not eat the fish and get a deficiency in omega-3 fatty acids. The opportunity cost of the deficiency is higher than that of theoretical risk from dioxin toxicity.
Another example is that of the reduction of aromatics in gasoline. An investment in the range of $100 million has been spent to reduce aromatics, motivated by the fact that aromatics are carcinogenic. However, the actual exposure to gasoline vapor and the resulting carcinogenity is statistically expected to lead to 3–4 fatal cancers annually. The opportunity cost is that $100 million could have been spent on more effective life-saving efforts,[5] e.g.: cancer research, to potentially save thousands of lives.
[edit] See also
- Cost of capital
- Opportunity cost of capital
- Economic value added
- Marginalism
- Net income
- Parable of the broken window
- Production-possibility frontier
- There Ain't No Such Thing As A Free Lunch
- Time management
[edit] References
- ^ McConnell, Campbell; Stanley L. Brue (2005). Microeconomics: Principles, Problems, and Policies. McGraw-Hill Professional. pp. 27. ISBN 0072875615. http://books.google.com/books?id=hlwqualKNjEC&printsec=frontcover#PPA27,M1.
- ^ Opportunity Cost Definition
- ^ James M. Buchanan (1987). "opportunity cost," The New Palgrave: A Dictionary of Economics, v. 3, pp. 718-21.
- ^ The Economist's definition of Opportunity Cost
- ^ Wittcoff, H.A.; Reuben, B.G.; Plotkin, J.S. Industrial Organic Chemicals, 2nd ed. John Wiley & Sons, Hoboken, New Jersey, 2004.
