What Is Opportunity Cost?
Definition
Opportunity Cost
Opportunity cost is the value of the next best alternative that is forgone when a decision is made to pursue one option over another. It reflects the benefits that could have been obtained if a different decision or investment had been chosen.
- Recall that because of scarcity, individuals, firms, and governments must make choices.
- The cost of any choice therefore, is not only what you pay in money, but also what you give up.
- Opportunity cost is central to economic thinking because it forces you to ask, "Compared to what?"
- If you choose one option, the real cost is the best option you could have chosen instead.
Analogy
- If you spend one hour revising economics instead of mathematics, the opportunity cost is the benefit you would have gained from the best use of that hour in mathematics (not the benefit of every subject you did not revise).
How Is Opportunity Cost Calculated?
- Opportunity cost formula: $$\text{Opportunity cost of good X in terms of good Y} = \frac{\text{Production volume of good Y}}{\text{Production volume of good X}}$$
Example
- Mexico: OC(1 avocado) = $\frac{150}{350} \approx 0.43$ blenders; OC(1 blender) = $\frac{350}{150}=2.33$ avocados
- Panama: OC(1 avocado) = $\frac{75}{150}=0.5$ blenders; OC(1 blender) = $\frac{150}{75}=2$ avocados
- So Mexico has the lower opportunity cost in avocados, Panama has the lower opportunity cost in blenders.
- If each specializes and they trade, total output available for consumption can rise.
Tip
- In a PPF diagram, opportunity cost is linked to the slope.
- A steeper frontier (in a given region) means a higher opportunity cost of the good on the horizontal axis.
How Does Opportunity Cost Show Up In Markets and Trade?
- Opportunity cost also appears in a market setting. When countries trade, consumers and producers face new choices because prices change.
- One way to represent imports is to use a supply and demand diagram.
- If another country can supply a good at a lower cost, the importing country faces a lower world price.
Interpreting the trade diagram
- Imagine a country like Australia importing low-tech manufactured goods from a large, low-cost producer such as China.
- Without trade, domestic supply (Sd) and domestic demand (Dd) intersect at price Pd and quantity Qe.
- With free trade, the world price Pw applies, which is below Pd.
- Foreign supply is perfectly elastic (horizontal) because the importing country is too small to influence the world price.
- At Pw, quantity demanded rises to Q4 and domestic supply falls to Q1.
- Imports under free trade = Q4 − Q1.
- When a tariff (t) is imposed, the domestic price rises to Pw + t.
- At Pw + t, quantity demanded falls to Q3 and domestic supply rises to Q2.
- Imports with the tariff = Q3 − Q2, which is smaller than under free trade.
Note
- Lower import prices usually increase consumer surplus (more consumers can buy at a lower price), while domestic producers may lose producer surplus because they cannot compete at the new price.
Example
- A firm investing in new machinery has the opportunity cost of other projects it cannot fund.
- A worker choosing one job has the opportunity cost of the best alternative job (including non-monetary factors like working conditions).
Exam technique
- Use the phrase "The opportunity cost of … is …" and always name the next best alternative explicitly.
- Marks are often lost when students describe a disadvantage in general terms but do not identify what is forgone.
Self review
- In your own words, explain why opportunity cost exists.
- Mexico can produce more of both avocados and blenders than Panama. Why might Panama still benefit from trade?
- In the import diagram, what does the distance Q2 - Q3 represent?
