Choice makes you face the opportunity cost, whether you realize it or not. At some time, you may have to choose between the two options that you both want. But, because your resources are limited (for example, you don’t have enough money in your pocket), you have to choose one and skip the other.
What is the opportunity cost
This concept applies to all economic decision making, both by consumers, businesses, and governments. And, the opportunity cost dimension might take the form of time, money, or utility.
Why you need to consider it
We have scarce resources, such as money and time. Affluent individuals, for example, have a lot of money. But, often, they have less time for family or personal pleasure. Or, they have limited time to make critical decisions, which may have consequences for their future.
Knowing the opportunity costs is essential for making the right decision. You need to consider it to maximize satisfaction and desire while minimizing risk, not only now, but also in the future.
How opportunity costs arise
Opportunity costs are the core of the economics concept. It arises when we have to choose the best from various alternatives in utilizing resources.
The economic goal is to satisfy our needs and wants as much as possible. But, we face limited resources. And, with these resources, we cannot fulfill all our needs and desires because they are unlimited.
We may have had stuff that we like, but we are unsatisfied and want something else. That’s why our needs and desires are unlimited.
Limited resources force you to make choices. When you choose something, you also sacrifice the next alternative. For example, you have to buy a smartphone. A dilemma arises because the money you have is not enough to buy both. You must choose one of the two brands that you prefer. The next alternative brand that you sacrifice is what represents an opportunity cost.
Because you have to sacrifice the next best alternative, you should be careful and rational. I mean, in that example, you have to choose the smartphone brand that gives you the most significant benefit or satisfaction. So, when you have chosen, you are satisfied.
And, in economics, rational consumers will maximize the satisfaction (utility) of the consumption of goods and services. On the other hand, rational producers will maximize profits from the resources they have. Both of these rationalities are critical assumptions in economics.
What are some examples of opportunity costs?
I will present three examples of opportunity costs.
Choose to increase education spending or infrastructure spending. For example, the government must choose two options to increase the productive capacity of the economy in the long run. Because the budget is limited, they must select two alternative expenditures: infrastructure or education spending.
Both are critical to promoting long-term economic growth. Infrastructure spending, for example, for road construction, reduces logistics costs and increases connectivity between regions. On the other hand, the education budget is also vital to increase labor productivity.
Investment in stocks vs. bonds. When you choose to invest your money in stocks, then you sacrifice the possibility of safer returns on bonds. You may pick stocks because they offer a higher return. And, that also comes with a greater risk.
Conversely, if you choose bonds, the return you get is probably lower. However, investment in bonds is relatively safer than stocks.
Buy a new machine or outsource. A company is facing increased demand, exceeding the current capacity. The company must decide whether it is profitable to buy a new machine or outsource its production to another company.
For example, demand increased from 100 units to 120 units. And, the production machine currently has a production capacity of 100 units and operates at full capacity.
Say, the company expects demand to continue rising. Buying a new machine might be the right option when high demand continues. By doing so, they can increase met the demand.
But, if the increase in demand is only temporary, outsourcing is the right choice. Say, the average demand is 90 units in a normal situation, and the industry is facing a decline in demand.
Calculation of economic profits
Economic profit entails opportunity costs (implicit costs). You can calculate it using the following formula:
Economic profit = Revenue – Explicit costs – Implicit costs = Accounting profit – implicit costs
Let’s take a simple example.
You start an electronics shop and sacrifices an opportunity to earn a salary of IDR100 in the largest electronics company. After operating, the store generates revenue of IDR1,000. You also incur a burden of IDR500 for electronic equipment supplies and IDR200 for employee salaries.
Because you miss a large salary by operating a store, if the store fails to generate economic profits, you fail to make more money.
From the case above, you forget IDR100 by operating the store. So, store accounting profit must be at least the same as this. Otherwise, running a store is an inefficient resource allocation option.
In this example, the economic profit from operating a store is IDR100 (IDR1,000 – IDR500 – IDR 200 – IDR100). Because economic profit is positive, opening a shop is the right choice. You get as much as IDR200 (accounting profit) instead of IDR100 if you work for a company.