Opportunity Cost Principle
The opportunity cost of a decision means the sacrifice of alternatives required by that decision. This can be best understood with the help of a few illustrations, which are as follows:
- The opportunity cost of the funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures.
- The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment.
- The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products.
- The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.
- If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.
- If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py.
- The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil.
For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under:
“The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.”
Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to national fund for buying armour has cost the nation of losing an opportunity of buying more butter. Similarly, a continued diversion of funds towards defence spending, amounts to a heavy tax on alternative spending required for growth and development.
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