Every day everyone makes a myriad of decisions, choosing between two or ten or even hundreds of different possibilities. Action tends to be the best indicator of preference, of what people actually want, but in doing so people deny themselves all other options. This is the essence of scarcity: everyone can't have everything all at once.
With every expressed preference there exists a next-best option: something you would have done if the first option wasn't available. This is called the opportunity cost. Because you do one thing, you've lost the opportunity to do something else. Opportunity costs can be thought of as a sort of regret, pain people bear as they imagine what they could be enjoying even if they are enjoying what they are doing right now more. Another way to think about opportunity costs is money value; profit you would have made if you did something else, such as a business venture.
Understanding Opportunity Cost and Benefit
Opportunity Cost can be understood by looking at the first four of Mankiw's Principles of Economics
- People face tradeoffs.
- The cost of something is what you give up to get it.
- Rational people think at the margin.
- People respond to incentives.
To exemplify these four principles we will use the following example:
It is a Friday night and you have the following options of things to do, in order of how much you want to do them (most enthusiasm to least enthusiasm):
- 1.)See a movie with a partner.
2.)See a movie with your buddies.
3.)Buy new jumper cables.
4.)Play chess against yourself.
By putting the partner first, you have already faced the tradeoff of friends vs more-than-friends. How was this tradeoff made? By weighing costs and benefits. Your benefit in this tradeoff is that you may be entering into a romantic relationship, rather than simply keeping the platonic ones you already have. But what about the costs?
Each of the above options has the cost of time. You only have one Friday night until next week, so, for now, you only have time to do one thing. Both of your top two options have the added cost of spending money at the cinema. However, the benefits of these options (namely being social and having fun with others) outweigh the costs so you have placed them above the others.
As stated before, for each of your top two options your opportunity costs include Time and Money. How do we know this? Because The Cost of Something is What You Give Up to Get It. Another way to remember this is with the adage "There Is No Such Thing As A Free Lunch," which means that there is some built-in cost for everything so nothing is truly free of charge. For each of the above options, you are spending your time and your money which could have been used on a multitude of different things. If you choose option one, you miss out on the next best option. That is, by choosing option one, you are giving up the opportunity of option two and it is therefore an opportunity cost. If you choose any option, you are giving up the other options to "get" your option.
The next thing to think about before making your final decision on what to do this fateful Friday would be does the opportunity benefit of option one outweigh the opportunity cost of option two? This is called thinking at the margin and is how rational decisions are made. In this example, if you choose option one, your friends might look down on you and say that you abandoned them to see your partner. Inversely, if you choose option two, you risk losing your partner to have fun with your buddies. For argument's sake, we will assume that although your friend's will hassle you for ditching them, they won't leave you and if you abandon you partner instead, he/she will leave you or be very angry with you. Therefore, seeing your buddies has a much greater opportunity cost than seeing your acquaintance does, so seeing your partner would be the rational decision - the decision made at the margin.
However, what if we throw in a twist to this example? What if option two has an incentive that makes option two a more rational decision than option one? This incentive could be that your friends want your partner to come with you if you decide to go with them? And they'll pay for your movie tickets? And give you a new car? These are incentives, and people respond to incentives.
Production possibility curve
Opportunity cost is the substance of production possibility curves, the opportunity cost of choices in current resource deployment on current production and future production capability.
The production possibility curve is a quarter curve 12pm-3pm, on a graph of two competing possibilities of production, with each product's quantity being the X and Y axes respectively.
Anything within the region left and under the curve, is the production possibilities, and represents what can be produced given the available resources.
Production is fully efficient on points lying on the curve, as resources are fully allocated, including employment.
If X is the horizontal axis quantity, then the right most, lowest point of the curve, shows maximum production of X, and no production of Y. Conversely, the left most, highest point, shows maximum production of Y, and no production of X.
The curve can grow outward, if relevant technology increases, or resources increase, the former representing increased maximum efficiency achievable.
An illustrative example might be X is the production of cars, and Y is the production of mobile consumer items. Assuming that enlarging the production possibility curve is good, what is the optimal current production of X and Y, that will increase the production possibility curve of X and Y in the future?
Another way of framing the example, X is the production of cars and mobile electronic consumer items, Y is education, completed research papers, public-owned solar panel production companies, and public, independent labor legislation (to increase productivity by reducing health-damaging effects of work commitments).