Example of Opportunity Cost

Definition

Opportunity cost refers to the value of the next best alternative that is given up when a choice is made, a concept first introduced by Friedrich von Wieser in 1914.

How It Works

Opportunity cost is a fundamental principle in economics that helps individuals and businesses make informed decisions by considering the trade-offs involved. When a company like Boeing decides to allocate its resources to produce more commercial aircraft, it must forgo the opportunity to produce other products, such as military aircraft or spacecraft. This means that Boeing's production of ~800 aircraft annually (Boeing annual report) comes at the cost of not producing other potential products. The opportunity cost of this decision is the potential revenue and profits that Boeing could have earned from producing those other products.

The opportunity cost of a decision can be measured in terms of the chance cost, which is the cost of forgoing the next best alternative. For example, if Ford decides to invest $1 billion in developing a new electric vehicle, the opportunity cost of this investment is the potential return that Ford could have earned from investing that $1 billion in another project, such as expanding its production capacity or developing new technologies. Ricardo's comparative advantage model (1817) can be used to analyze the opportunity cost of trade-offs between different economic activities.

The opportunity cost of a decision can also be influenced by sunk costs, which are costs that have already been incurred and cannot be recovered. For example, if General Motors has already invested $500 million in developing a new vehicle platform, the opportunity cost of abandoning that project is the sunk cost of $500 million, plus any additional costs that would be incurred to develop a new platform. This highlights the importance of considering opportunity costs when making decisions, as it can help individuals and businesses avoid sunk cost fallacy, which is the tendency to continue investing in a project because of the resources that have already been committed to it.

Key Components

• Trade-offs: Opportunity cost involves trade-offs between different alternatives, and the value of the next best alternative that is given up is the opportunity cost.
• Scarcity: Opportunity cost is a result of scarcity, as individuals and businesses have limited resources and must make choices about how to allocate them.
• Alternative uses: The opportunity cost of a decision depends on the alternative uses of the resources being allocated, and the value of the next best alternative that is given up.
• Sunk costs: Sunk costs can influence the opportunity cost of a decision, as they are costs that have already been incurred and cannot be recovered.
• Comparative advantage: The opportunity cost of trade-offs between different economic activities can be analyzed using Ricardo's comparative advantage model (1817).
• Marginal analysis: Opportunity cost can be analyzed using marginal analysis, which involves evaluating the marginal benefits and costs of a decision.

Common Misconceptions

Myth: Opportunity cost only applies to economic decisions — Fact: Opportunity cost applies to all decisions, including personal and social decisions, as it involves trade-offs between different alternatives (Friedman, 1962).

Myth: Opportunity cost is only relevant in the short run — Fact: Opportunity cost is relevant in both the short run and the long run, as it involves considering the trade-offs involved in making decisions (Marshall, 1890).

Myth: Opportunity cost is the same as marginal cost — Fact: Opportunity cost is different from marginal cost, as it involves considering the value of the next best alternative that is given up, while marginal cost involves considering the additional cost of producing one more unit of a good or service (Bohm-Bawerk, 1889).

Myth: Opportunity cost is only relevant in a perfect market — Fact: Opportunity cost is relevant in all markets, including imperfect markets, as it involves considering the trade-offs involved in making decisions (Robinson, 1933).

In Practice

The opportunity cost of Amazon's decision to invest $5 billion in its drone delivery program is the potential revenue and profits that Amazon could have earned from investing that $5 billion in other projects, such as expanding its cloud computing services or developing new artificial intelligence technologies. This decision involves trade-offs between different alternatives, and the value of the next best alternative that is given up is the opportunity cost. Amazon's investment in drone delivery is expected to generate $10 billion in revenue annually, but it comes at the cost of not investing in other potential projects that could have generated similar or higher returns.