Opportunity Cost (Managerial Economics)

Opportunity cost is the value of the most valuable of all the options that one has to forego while choosing from a set of options.

In Managerial Economics, the opportunity cost is a useful concept as it helps in making decisions, especially when the manager has to make choice between different alternatives. Most business activities are carried on within constraint (‘scarcities’) which force choices and consequent sacrifices to be made.

In the corporate environment, managers often have to take decisions where they might have to forego the production of one commodity to fund the production of another commodity, or forego few projects to fund some other project.

And it applies in real life as well; almost every person and household applies the concept of opportunity cost in real life. Opportunity cost is the value of the most valuable of all the options that one has to forego while choosing from a set of options.

This is the basic concept of opportunity cost and it arises only because some essential input, money or capacity, is scarce and insufficient to take up all the options that are desirable.

Opportunity Costs are important when considering make-or-buy decisions, and also when deciding whether or not to sell something. Opportunity cost is also used to analyse capital projects. The discount rate used to find out net present values when evaluating capital projects is nothing but an opportunity cost of capital.

Here are a few more examples of opportunity cost that usually arise in business environment.

• The opportunity cost of using a machine is the most profitable alternative sacrificed by employing the machine in its present use.
• The opportunity cost of working for oneself (applies to most entrepreneurs) is the salary that one could earn in others occupations.
• The opportunity cost of funds used in one’s own business is the interest that could be earned on those funds by investing it elsewhere.
• The opportunity cost of buying a color TV for the reception area is the interest or profit that could be earned by investing the purchase money.

So opportunity cost requires the measurement of sacrifices, be it real or monetary. However, some decisions require no sacrifices to be made and is cost free. In the above example, if the machine was lying idle, then the opportunity cost of using that machine for production is zero. If there were no constraint of money or capacity, there would be no need to sacrifice and hence no opportunity cost would arise. Also, opportunity cost is just a notional idea which does not appear in the books of account of the company.

This is the basic concept of opportunity cost; it arises only when some essential input such as money or capacity is scarce and insufficient which prevents us from taking up all the desirable options. If there were no constraint of money or capacity, there would be no need to sacrifice and hence no opportunity cost would arise.

Example

Every family has limited income and access to resources. Each member in the family may have a long list of shopping items that he or she may want to buy, but not everybody has the budget to buy all the things. That is where people are forced to make a choice; one has to forego few things in order to buy other things.

For example, a family may like to spend a Sunday by having breakfast at a restaurant, followed by a trip to a place like Kidzania, followed by lunch at Barbeque Nation, followed by a movie at the theatres. However, for a family of four, this itinerary could mean spending up to 10 thousand rupees in a day. So the family may be forced to reconsider the various options. Maybe they would now have breakfast at home and leave; they could replace Kidzania with a visit to the zoo or to the beach; they could replace Barbeque Nation with some other inexpensive restaurant.

Here’s another example. Say a carpenter gets work to make furniture in family A. After analysing the requirements and time required, he gives a quote of Rs. 25,000 for the work. Suppose, in the meantime, two other families B and C, reach to him to do their work. These two families are ready to give him work worth Rs. 15,000 and Rs. 20,000, respectively.

However, they all need the work to be done in the same week and the carpenter doesn’t have the bandwidth to accept multiple work. In that case, he would accept the work of Family A, the most profitable one, and let go of the other two. His opportunity cost in this case would be Rs. 20,000, the sacrifice of the next best option. Had he chosen either family B or C, his opportunity cost would have been Rs. 25,000 profit that he would have earned from family A.

We once went to a mall for shopping; when browsing through the various shops, we reached a computer store and a friend of mine said that she wanted to order a printer for home use. She was trying to decide between two printers, one of which cost Rs.25000 and had more features as compared to a second printer that cost Rs. 18000. After spending a lot of time thinking about what to choose, the salesman present at the store asked her whether he would rather have the printer with more features or opt for the cheaper printer and have Rs. 7000 worth of cartridges for the printer. Immediately, she selected the cheaper printer along with those extra cartridges.

In this case, the money that was not spent on the printer was made available for other purchases, in this case cartridges that would come in handy once the printer got into use at home. While paying for the printer at the checkout, we bumped into the owner of the store who happened to be someone whom I knew. I told him that he had a nice store. But he told me that while the place was good, the rent in the mall was too high. Offices located few blocks away from the mall were available for 30% less rentals, without much change in footfalls. He felt he could have spent that extra money in his business for buying more goods or for hiring extra staff.

That is when I realised that we often find ourselves in situations where we have to make choices. In some cases, the choice is between buying an item (say a purse) and not purchasing it. In other cases, the choice is between a more expensive option and a less expensive option.

It also occurred to me that people generally don’t usually think about opportunity costs when making choices, unless they are reminded of it by another person.

I personally observed that when I was shopping with my friends in the other stores in the mall; I saw was that my friends bought the cheaper option (or did not purchase at all) when they were reminded of the opportunity cost of making the purchase.

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