Opportunity cost

We live in a world of scarcity, in the sense that we can never have everything that we might like. As a result we must make choices, for instance whether to buy this or that, whether to eat this or that, whether to walk in the park or go to a movie, or whether to produce this or that. Every time we make a choice to do some- thing we automatically exclude something else that we did not do we have given it up. We call this the “opportunity cost”.

Definition “Opportunity cost is the best forgone alternative”
i.e. it is what we gave up to get what we did. The opportunity cost of buying new pair of shoes might be a lunch forgone.
· The opportunity cost of buying a new shirt might be not going to the cinema.
· The opportunity cost of taking a part-time job might be not being able to hang out in the mall with your friends.

For a producer
The opportunity cost of buying plastic packaging material might be the cardboard he did not buy.

NB there can be many alternatives foregone, but only one will be the opportunity cost you cannot add them up and say they are all the opportunity cost, because it must be a choice between them.

Opportunity cost can be thought of as:

1. The cost in pounds (represents a real thing given up); or
2. The cost in time.

Opportunity cost is important

1. We use it whenever we are deciding what to do, for example shall we hire a couple of videos or buy a piz- za instead.

2. It always arises with budget allocations. At some point in your life you may have to draw up a budget and allocate money for different purposes. You will be forced to weigh up what is really needed in your tennis club, computer society, your country or whatever.

3. It lies behind the cost curves that we draw. How does this work?

Consider two producers, A and B. Producer A might have to pay £20 a ton to get the iron ore to make into motor cars. Producer A sees the cost as £20, but we see it as the way of making sure he gets the resources, rather than letting B get them! So the opportunity cost really does stand behind the cost curves we draw.

Similarly in consumption: if something costs £10, you have to pay £10 to buy it. That £10 is not only the price of the object, it is also the amount you have to pay to get the resources, raw materials, labour etc. that went into making it. This prevented these resources from going into making something else.

After you buy the item it will be reordered by the shopkeeper and replaced on the shelf. S/he orders from a wholesaler who in turn orders more from the producer. The producer then buys the raw materials etc. to make another of whatever you bought! In this way, resources keep on going into making whatever people demand.

4. This is how the price mechanism really works – that is, how it allocates resources to wherever the de- mand is the greatest.