Opportunity cost

 

Opportunity cost 

Opportunity cost is the sacrifice made in making an economic decision, expressed in terms of the next best available alternative foregone. It is a central concept in economics and is often regarded as the ‘true cost of an economic decision.

Production possibility frontiers

An opportunity cost will usually arise whenever an economic agent chooses between alternative ways of allocating scarce resources. The opportunity cost of such a decision is the value of the next best alternative use of scarce resources. Opportunity cost can be illustrated by using production possibility frontiers (PPFs) which provide a simple, yet powerful tool to illustrate the effects of making an economic choice.

A PPF shows all the possible combinations of two goods, or two options available at one point in time.

Production possibilities

Mythica, which is a hypothetical economy, produces only two goods – textbooks and computers. When it uses all of its resources, it can produce five million computers and fifty five million textbooks. In fact, it can produce all the following combinations of computers and books.

COMPUTERS (m)	TEXTBOOKS (m)
0	70
1	69
2	68
3	65
4	60
5	55
6	48
7	39
8	24
9	0

These combinations can also be shown graphically, the result being a production possibility frontier. The production possibility frontier (PPF) for computers and textbooks is shown here.

Interpreting PPFs

Firstly, we can describe the opportunity cost to Mythica of producing a given output of computers or textbooks. For example, If Mythica produces 3m computers; the opportunity cost is 5m textbooks. This is the difference between the maximum output of textbooks that can be produced if no computers are produced (which is 70m) and the number of textbooks that can be produced if 3m computers are produced (which is 65m). Similarly, the opportunity cost of producing 7m computers is 31m textbooks – which is 70 – 39.

PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good. For example, suppose Mythica currently produces 3 million computers and 65m textbooks. We can calculate the opportunity cost to Mythica if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B.  and textbooks is shown here.