Opportunity Cost
One of the lamentable facts of life is that nobody can have everything that he or she wants. This is due, in part, to scarce resources. Whether a teenager with a part-time job or a wealthy business-person, no single person owns all of the money in the world. Furthermore, there are only twenty-four hours in a day, and seven days in a week. Time and money are only two of the many resources that are scarce in day-to-day living.
Unfortunately, because of these limits, individuals have to make choices in using scarce resources. One can use his or her time to work, play, sleep, or pursue other options. Or, one can select some combination of possible activities. People can't spend twenty-four hours a day working, twenty-four hours a day playing, and twenty-four hours a day sleeping. People can choose to spend their salary on a nice house, an expensive vacation, or on a yacht, but they probably can't afford all three. They must make choices with their limited resources of money.
In making choices for using limited resources, it is reasonable to evaluate the costs and benefits of all possible options. For instance, suppose one has been trying to decide how to spend the next few years of one's life. He or she has narrowed the options down to two: (1) working at a full-time job, or (2) becoming a full-time student. Going to school will cost approximately $12,000 per year in tuition, books, and room and board at the local state university for the next four years. In addition, he or she will forego the salary of a full-time job, which is $24,000 per year. This makes the total cost of going to school $36,000 per year. In return he or she gets the pleasure, social interaction, and personal fulfillment associated with gaining an education, as well as the expectation of an increase in salary through the remainder of his or her work life.
The question that must be answer is, "do the benefits of education outweigh the costs?" If they do, school should be selected. If the costs are greater than the benefits, the full-time job should be kept.
An "opportunity cost" is the value of the next-best alternative. That is, it is the value of the option that wasn't selected. In the example, if the person had chosen to keep your job, then the opportunity cost is the benefit of going to school, including the intangible benefits of pleasure, social interaction, and personal fulfillment as well as the tangible benefit of an increased future salary for their remaining working life. If the person had chosen to go to school, then the opportunity cost is the $24,000 per year that would have been earned at the full-time job.
One way of visualizing this concept is through the use of a production possibilities curve—a graph that relates the tradeoff between two possible choices, or some combination of the possibilities. Consider a very simple possible economy for a country. This country can produce two goods: guns (i.e., defense) or butter (i.e., consumer goods). If this country has historically used all of its resources to produce guns then it may be willing to consider allocating some of its resources to the production of butter. Initially, the resources that are least effective in producing guns (e.g., farmland) will be reallocated to the production of butter. Thus, the country doesn't forfeit many guns to produce a relatively large amount of butter. However, as the country reallocates more resources to the production of butter they are decreasingly productive. At the extreme, when the country gives up the last of its production of guns, the resource is very good for producing guns and not very useful in the production of butter (e.g., a high-tech armaments production facility). Figure 1 demonstrates this situation graphically in showing an example of the production possibilities curve.
In Figure 1, everything on the curved line or in the gray area is a possible production combination of guns and butter in the simple economy. Any combination on the line uses all of the available resources, while any combination in the gray area is considered inefficient since it does not use all of the available resources. Any combination in the white area is impossible to achieve, given the country's resource limitations.
The idea that the country will initially reallocate its least productive resource to the production of the other good is known as the law of increasing opportunity cost. Thus, if the production of the initial ton of butter costs five hundred guns, then the next ton of butter, which uses resources that are better at producing guns, will cost more guns. The next ton of butter will cost still more guns, and so on. This is represented in Figure 1 by the changing slope of the production possibilities curve.
Summary
Because resources are limited, choices must be made. When evaluating choices in this decision making process, one attempts to select the best option; that is, one selects the option that offers the most benefit for the costs incurred, and which are possible given any constraints. This is true for individuals, businesses, or countries, though the decisions that each entity makes are vastly different. The second best option is called the opportunity cost and is what is given up when decisions are made.
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