Opportunity cost is one of the first concepts students need to understand when they study Economics. Most definitions refer to “the cost of the alternative or the cost of what is foregone”. Many times I have seen students struggling to understand, what I consider to be, such a simple concept.
Well, maybe, it is not as simple as I think.
The first thing that we discuss in my Introduction to Economics classes is that all the questions in Economics arise from the fact that we want to have and do everything, but we do not have the resources (natural, money or even time) to do and have everything (i.e. scarcity). As a result, we need to make sacrifices. These sacrifices could involve costs that can be easily measurable (let’s call them explicit), such as the price of a good, and those that are not easily measurable, the implicit costs.
Let’s assume we are considering whether we should go to work for 2 hours and earn £100 or go to a cinema and watch a 2-hour film instead. So what is the opportunity cost of going to the cinema (what would I sacrifice)? First we have the money cost of the cinema (assume that with pop corn and drinks it costs you £15) and then we have the time cost of cinema, you need to “sacrifice” 2 hours. So, what else you could have done? You could have worked for 2 hours to earn £100 and not spend £15 for ticket and food. So the opportunity cost of this decision (going to cinema instead of going to work) is £115, i.e. the value of your “sacrifice”.
We can also consider it in terms of a firm using resources in production. Let’s assume that I have a machine that can produce beer and pizza and the only resource it needs is time (what a wonderful world would that be!). My machine needs 4 hours to produce pizza and 6 hours to produce a pint of beer. So what is the opportunity cost of producing a pint of beer, what am I sacrificing? My machine will need 6 hours for a pint of beer, so the question really becomes, how much pizza can I make in that time? I need 4 hours for 1 pizza so (assuming that we can get slices of pizza as well) in 6 hours I can produce 1.5 pizzas. So the opportunity cost of producing a pint of beer is 1.5 pizzas*.
This concept is very important in Economics and plays an important role in different decisions, for example international trade and investments, but more on this in a future post.
*Note that to calculate the opportunity cost in this case we have divided the value of resources for the good we are producing (for a beer is 6 hours) with the value of the resources for the good we sacrificed (for pizza is 4 hours).
Nikos Tzivanakis 