OPPORTUNITY COST

In economics, Opportunity Cost refers to the cost of pursuing a certain choice in terms of the other choices foregone as a result. Clearly related to the earlier concept of scarcity, opportunity costs also plays a central role within economic theory – a role which is traditionally illustrated using an imaginary country which only has the means to produce two products: guns, and butter. To be more exact, this economy can produce a maximum of 100,000 guns using all available resources, or a maximum of 100,000 tons of butter instead. Therefore, the opportunity cost of producing 50,000 tons of butter may be that the remaining resources available are now only able to produce 50,000 guns. Conversely, if the economy chose to produce 25,000 guns, it may only produce 75,000 tons of butter compared to a maximum output of 100,000 tons if all resources were allocated to butter production – resulting in an opportunity cost of 25,000 tons of butter.

We can illustrate the concept of Opportunity Cost visually using a diagram to depict the Production Possibility Frontier (PPF), which connects the various combinations of two products which can be produced using all available resources within the economy. Normally, this is a curve as opposed to a straight line, due to the Law of Diminishing Returns.

Using our earlier example, The Law of Diminishing Returns implies that while it’s relatively easy to switch production from butter to guns when fewer guns are being made, the costs of manufacturing another gun in terms of tons of butter increases as butter becomes scarcer. Therefore, the economy will always operate on or within the PPF.

Even though almost every economic decision has multiple alternatives, most economists estimate opportunity cost by considering the next best alternative choice that could be made. So, for example, the opportunity cost for paying annual university tuition fees may be a deposit of a house, or a luxury holiday. On a macroeconomic scale, the opportunity cost of NASA sending an unmanned probe to Mars could be an additional aircraft carrier, or increased spending on Medicare and other associated social welfare programs.

It’s important to consider that opportunity costs do not represent the sum of all alternative choices – merely the cost of a single alternative. However, this raises the important question as to which alternative to consider – a question which can be answered relatively easily by ascertaining the market price of each alternative. This approach though presents its own difficulties, since many alternatives may not have a market price, yet still have value over and above what the market may dictate. For example, how would one measure the market price of things such as clean water, fresh air, or an unspoiled environment? Since these intangibles have costs which are difficult to quantify, they are usually prime examples of resources which are ignored or overlooked when analysing opportunity costs.

To resolve these complications therefore, economists have developed the concept of Spill over Effects. For instance, if a paper mill emits pollution into a nearby river, it will impose negative spill over effects to the livings of local fishermen operating further downstream. However, not all spill over effects are negative – the construction of a new school may have a positive spill over effect if it increases the prices of homes within its immediate vicinity.

Typically, though, spill over costs impact a narrow group while spill over benefits usually impact a much larger section of society. This is another reason why government regulation is imperative to protect the individual rights of small minorities and communities in ways that the normal operation of the market mechanism would be either unwilling or unable to.

At the other end of the spectrum are special interest groups, which have a vested interest in ensuring that the negative spill over effects of the organizations they represent are downplayed while the positive spill over effects are emphasized. These groups then use political power to lobby politicians into diluting legislation designed to curtail regulation of specific sectors of the economy from tobacco firms to the automotive industry.

All these ‘ground-level’ factors further increase the difficulty of determining exactly what the opportunity costs are for certain actions, which by nature are highly empirical and thus not particular amenable to quantitative methods. Referring to our earlier example, quantifying the real impact of changes in butter production in terms of the impact this would have on gun production in an economy as complex as that of the US would be practically impossible.

Because of this, opportunity cost is normally calculated within well-defined monetary terms. On a macroeconomic level, this could mean that an increase of £20Bn on defence spending would mean that central government would have £20Bn less to spend on improving the transport infrastructure. On a microeconomic level, this could mean that spending £2000 on a family holiday would mean £2000 less being spent on a brand-new car for example.

So, although opportunity costs can be difficult to pin down, their effects are both significant and wide-ranging. This is since opportunity costs are a factor in all decisions, since every choice implies foregoing at least one alternative option. Ignoring these costs therefore can undermine the decisions made by policy-makers who may have little or no awareness of the negative ramifications of the choices they make.

These types of scenario lead the French economist Frederic Bastiat to devise the Broken Window Fallacy. In it, Bastiat describes a schoolboy who breaks a window pane while playing, prompting his father to pay to have the broken window repaired. Instead of being scolded however, the boy is praised for stimulating the economy by generating employment for the glass worker who repairs the broken window – leading to everyone within the community to break every window within the town!

Economics is sometimes referred to as the science of marginal changes, with examinations of what happens because of incremental variations forming a large part of economic theory and analysis. For this reason, opportunity cost plays the vital role that it does within economics precisely because it provides a tool for measuring those incremental changes.