Opportunity Costs

One of the most critical concepts in economics is the concept of opportunity costs. It is the most fundamental issue of economics as a social science and explains the decision-making and behavior of economic subjects (or agents). Economic agents are private households, firms, and the government as a public household. While explaining the economic concept of opportunity costs, focus on why people choose to do, consume, or even spend time and resources on what they do. How do you make your choices and decisions?

1. Introduction: Definition of Opportunity Costs

How can we define opportunity costs? Opportunity costs are costs incurred by a forgone alternative (opportunity). A foregone opportunity can either be the opportunity to incur costs, gain revenues, earn profits, or cause losses. Economic subjects constantly get involved in decision-making processes, where choices must be made, e.g., social interactions between members of society within a certain social order. Take the following examples:

1.1 Non-Monetary Opportunity Costs

Example 1: non-monetary opportunity costs – the reason why a student would attend high school (an institution of education) is determined by the opportunity cost incurred if the student would not attend the school e.g. the impression of the parents about their daughter or son. Such opportunity cost are not measurable in monetary units, but can me explained using preferences and utility as quantifiers of level of satisfaction.

1.2 Mental Accounting

Examples 2: mental accounting – whenever you act or choose not to act in certain manner, you are weighing alternative options and therefore intrinsically accounting for cost that would be incurred by alternative mode of behavior. Depending on time, location and environmental conditions people make decision about activities, reactions and tactics.

1.3 Relative Costs between Alternatives

Example 3: relative costs – a job-seeker may prefer a job that pays less but offers a better work-life balance at the expense of a better-paying job under a worse work-life balance.

1.4 Specialization and relative costs or benefit

Example 4: Specialization and relative cost/benefit advantage – the opportunity cost of Germany producing autos are the cost incurred for not producing other goods that Germany prefers to import from other countries, e.g. Coffee from Kenya. Alternatively Kenyan industries can consider the opportunity costs of adopting new technologies that enable them to serve both local and international markets with innovative products.

2. Opportunity Cost theory in Microeconomics

You may learn the concept of opportunity costs in the course, foundations of economics, but the technical details are introduced in the decision-making theory in microeconomics. For example, household choices to consume goods and decision of firms to produce goods rely on the concept of opportunity costs. Those who are thinking of setting up a business will also try to select from several alternatives and weigh their advantages against each other.

2.1 Opportunity Costs in Household Decision-making

In the Microeconomics household decision-making problems, households face the challenge of selecting the bundle of goods and services that best satisfies their needs. In this case, imagine a household in a shopping mall with an empty cart. After several rounds, the fuller the cart gets, the more critical the choice between adding one more unit of goods. The Household will have to decide at the margin quantifying the opportunity cost of adding one more unit of a good into the cart at the expense of leaving some units of the second-best alternative, e.g., one unit of chocolate at the cost of half a litter of milkshake.

The household must consider two types of opportunity costs: preference-based and budget-based opportunity costs. Preference-based opportunity costs quantify the marginal rate of substitution (as the slope of indifference curves) between the marginal utility of the foregone unit of the commodity relative to the gain of additional marginal utility of accessing an extra unit of the preferred commodity. Budget-based opportunity costs, on the other side, quantify the opportunity cost of allocating the household’s resources efficiently, measured in the relative price of the preferred commodity relative to the price of the foregone commodity in the cart.

Consequently,  opportunity costs quantify the measures considered during decision-making and, therefore, shape the actions and behavior of households in their social interactions with other economic agents.

2.2 Opportunity Costs in Production Processes

In the Microeconomics production optimization problem of firms, the production of goods and services depends on the product technology that limits the efficient use of resources and the cost restrictions that firms face. Therefore, firms must also make decisions at the margin by choosing an efficient and optimal allocation of resources in the production processes.

The firms quantify two types of opportunity costs: technology-based and cost-restriction-based opportunity cost. The technology-based opportunity costs align the firm’s decision-making with the technological requirements. The firm can measure the opportunity costs in units of the marginal rate of technical substitution (as the slope of an isoquant) set as the marginal product of one resource relative to the marginal product of the second-best input. Conversely, the cost-restriction-based opportunity costs capture the alignment of the firm’s decision-making with the scarcity of resources. The firm can measure the opportunity costs as the relative price of inputs.

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Literature about Economics

The following Literature will help you to expand the spectrum of knowledge in this Field: