The importance of opportunity cost in decision making
It is vital to discourse prudently the opportunity cost and its importance in the practical life by discussing in detail the concept of opportunity cost in the light of different economists and authors and its value in the decision making of everyday life. In this discussion, a broader meaning of the opportunity cost will be given and its relevance with scarcity and choice. Moreover, the significance of opportunity cost will be shown in the context of decision making pitfall, exchange and opportunity cost, the relation of opportunity cost and specialisation with respect to the principle of comparative advantage and it relevance to trade. Furthermore, its importance in the business decision making, objective of maximising the profit, its relevance to the cost of capital, difference in economists and accounting point of view regarding opportunity cost will be considered with relevant explanation. In addition to this, the affiliation of opportunity cost and markets, opportunity cost of political decisions, opportunity cost for society and the opportunity cost of holding money will be analysed to manifest the meaning and significance of opportunity cost.
Opportunity cost is a simple and one of the most significant concepts of microeconomics (Frank: 2003). McDowell et al. (2009) describes, opportunity cost of engaging in an activity is the cost of the next most desirable alternative activity that a person have to give up in order to engage in that activity. Giving a simple example of opportunity cost, McDowell et al. (2009) suppose that a person is indifferent in choosing the amount of time to spent on either studying for a very important test or watching a favourite programme on television. In this case the opportunity cost of watching the television is the value of the study for the test that must be sacrificed, which is very high, and the person is very highly unlikely to watch television and is more likely to decide against watching television. Sloman (2006) illustrate that as there are scarce resources in the world, so people have to make choices among scarce resources, which involves sacrifice of alternative goods or services. Spending more money on food involves sacrifice of other goods and services. This sacrifice of other goods and services is known as its opportunity cost. Sloman (2006) called opportunity cost as a ‘threshold concept’. Once people become aware of its vitality, they start thinking like economists and it affects the way of dealing with economic problems. However, the way of thinking like economists and dealing with economic problems is different from accountants thinking and dealing, which will be discussed later in detail. Sloman (2006) claim that people start recognising that they face trade-offs, when they begin looking at the opportunity cost. That means engaging more in one action involves doing less of other activities. Nations face trade-offs and is widely known as ‘Gun versus butter’ trade-off. The more a country will spend on its defence, the less it will be left to spend on the welfare of its people and basic consumer necessities.
McDowell et al. (2009) and Frank (2006) both claim and agree that decision makers quite often ignore opportunity cost and do not take it into consideration while making a decision and this behaviour is one of the most common decision making pitfall. Rational people always apply the cost-benefit analysis to their decision making process, that is an action has to be taken if and only if its extra benefit is greater than its extra cost, but the common problem amongst many of the decision makers is that they ignore the implicit costs. However, taking forgone opportunities into account is vital for a prudent and intelligent decision making. Economists suggests that problem of overlooking opportunity costs can be avoided by translating questions such as ‘Should I watch the television programme?’ into ones like ‘Should I watch television programme or should I study for my test?’. Frank (2006) in an example of a similar type of question illustrates the significance of opportunity cost. A person faced with a question ‘Should I go skiing today or work as a research assistant?’. Going skiing and spending that day on the slopes worth £60 to that person and the explicit cost for that the day is £40. However, it is important to take into account the implicit cost, which is the value of the next most desirable activity forgone by going skiing because the explicit cost is not the only cost of going skiing. If that person did not go skiing, he/she can work as a research assistant with his professor and get a pay of £45 for that day. Here the cost of going skiing is not only the explicit cost of £40 but also the opportunity cost of £45 of working with professor, so the total cost of going skiing is £85. Making a decision in terms of the cost-benefit analysis, the cost of going skiing £85 is greater than the benefit of £60. Thus, that person should work as a research assistant and anybody who would ignore the opportunity cost will make a wrong decision and go skiing.
Opportunity cost also helps in explaining the fact that people should focus on those activities in which they perform better relative to others (McDowell: 2009). In other words, it helps to explain the far more productivity of the economic systems based on specialisation and the exchange of goods and services relative to less specialised economic systems. The nature of specialisation being so productive is due to an economic principle called ‘Comparative advantage’; that is in carrying out an activity, a person has comparative advantage over another person, if his opportunity cost is lower than the other person’s opportunity cost in performing that activity. In the same way, if two nations have different opportunity costs, exchange or trading of goods and services between the nations will help to increase the value of available goods and services by properly utilising the scarce resources (ibid). Mankiw (2006) posing a question that ‘whether United States should trade with other countries or not?’. As discussed, that nations can also benefit from specialisation and trade as individuals do. Many of the products used my Americans are imported products, whereas many of products exported from America are used abroad. In order to see the benefit countries get from specialisation and trade, suppose two countries America and Japan and two goods cars and food. Let us suppose further that both the countries are equally efficient and well in producing cars. A Japanese and American worker, both produces one car in a month. However, in case of food, as America has more and better fertile land than Japan, its workers are better in producing food than Japanese workers, and assume American worker produce 2 tons of food per month as compared to a Japanese worker, who can produce only 1 ton of food in a month. Now according to the principle of comparative advantage, the country should produce that commodity in which its opportunity cost is lower compared to the other good. So, as the opportunity cost of Japan is 1 ton of food for producing a car per month, whereas the opportunity cost of America is 2 tons of food. Clearly, Japan’s opportunity cost is lower in terms of the production of cars and it has a comparative advantage in producing cars. America should produce food more than its personal consumption and export it to Japan, whereas Japan should produce more cars than its personal use and export it to America. In this way, both countries can produce more of both goods through specialisation and can have more food and cars through trade.
Samuelson and Nordhaus (2004) are of the view that the opportunity cost is also involved in the business decisions. Generally, the business accounts do not show the opportunity costs on their profit and loss statement and includes only those transactions in which tangible money is involved (Meigs et al.: 1999). However, the economists include all costs whether they reflect the monetary costs or not. Mankiw (2006) claims, the most important implicit cost in every business decision making is the cost of the financial capital that the owner invest in the business. For instance, a person has invested a capital of £300,000 to buy a new factory. Alternatively, this capital amount of £300,000 could be deposited in a saving account and the owner could earn £15,000 at an annual interest rate of 5 percent. To buy the factory, the person has actually forgone an annual amount of £15,000, which is the implicit or opportunity cost of investing in the business. Pacillo (2010) gave an equation for the calculation of the overall economic cost by simply adding up the explicit financial cost and the opportunity cost. The equation is as follows:
Total Economic Cost = Total financial cost + Total opportunity cost
This illustration of difference in measurement of economics cost and accountants cost is significant for the fact that it leads us to a more important objective of a firm’s economic profit. Similar to the difference in cost, the accountants and economists also differ in the measurement of profit (Mankiw: 2006). In analysing the firm’s profit, the economists subtract from revenue all the opportunity costs (implicit and explicit both) to measure firm’s economic profit, whereas the accountants just subtract the firm’s explicit costs to calculate firm’s accounting profit, that is why the accounting profit is usually larger than the economic profit. From economist’s point of view, for a firm to be profitable its economics profit should be positive and must cover all explicit and opportunity costs. The concept of economic profit is of great significance because a firm making positive economic profit will remain in business (ibid).
Furthermore, it is also very important to know the opportunity cost of holding money or in other words, hoarding. The opportunity cost of holding money is the sacrifice of the interest that a person must incur by not depositing the money into interest bearing account or investing in another business (Samuelson and Nordhaus: 2004). Suppose that a person deposit £1000 into a saving account at the start of a year and earn 5 percent annual interest. By the end of the year he/she would have £1050 in the account. By contrast, if a person does not deposit the money into saving account and hold it as currency, he/she would end up with the same amount of £1000. In this case, the opportunity cost of holding money would be £50.
Hence, from the above discussion the concept of the opportunity cost has been explained along with its importance in daily life. It is important to take opportunity cost into account in every kind of decision making. It is not only important for the economists but also for the common rational people to take opportunity cost into account to increase utility and to make better choices amongst scarce resources, which is the basic theme of studying the subject of economics. The importance of opportunity cost for the poor countries is also evident through the explanation of comparative advantage, that poor countries should focus on those activities in which their opportunity cost is lower as compared to other countries to increase the standard of living by trade. Moreover, for businesses to make better profits, it is important to consider economics costs and profits. However, the explicit costs can always be measured and estimated but it is sometimes very difficult to estimate the implicit costs, where the businesses needs to rely on accounting costs for the sake of book keeping. At the end, the simple and most relevant to common people is the opportunity cost of holding money. People think that by holding money in terms of cash, they do not incur any cost but they are usually unaware of the forgone opportunities that could have increased their wealth and made their life better-off.
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