Definition: Economics studies

Opportunity Costs

- how choices are made

- from among alternatives - under conditions of scarcity. Economics as a discipline exists because resources are scarce.
Scarcity exists when the necessary resources for producing the things that people desire are insufficient to satisfy all wants.

If there were no scarcities, there would be no need to make choices. If there are no alternatives available, then the freedom to choose has very little meaning. Choosing a particular alternative means comparing the benefits and costs of that alternative.

Opportunity cost
Let B(Z) be the benefits from choosing alternative Z, and C(Z) be the costs of choosing Z. Then h Z should h ld b be chosen h if B(Z) ( ) > C(Z), ( ) not otherwise. B(Z): maximum rupee amount you would be willing to pay to do or choose Z. C(Z): rupee value of the resources you must give up in order to do Z.

As the definition of C shows, the cost must be calculated with reference to the other alternatives that were forgone. Definition: The opportunity cost of an action refers to the rupee value of the next best alternative forgone.

Even though opportunity costs include lots of non-monetary costs, we often monetize opportunity costs, translating the costs into rupee terms for comparison purposes. Monetizing opportunity costs is clearly valuable, because it gives a means of comparison

Costs are tied to actions, not things.

Pitfall in the Calculation of Opportunity Costs

Hidden Costs: costs that should be included but often are not Some of S f th the costs t are implicit i li it and d some d do not have any direct monetary valuation. One might easily overlook them in the computation of opportunity cost.

EXAMPLE Arun works as a waiter during weekends and earns Rs.100. A couple of his friends are trying to persuade him to go holidaying with them next weekend. They will bear the cost of transportation. However, Arun will have to pay his share of lodging which will be Rs.50 and also pay Rs.40 as meal charges. Arun calculates that the opportunity cost of holidaying is (a) Rs.100. (c) Rs.90. (b) Rs.190. (d) Rs.150.

Accounting costs are derived from financial reports that mainly categorize explicit rupee payments. As a result, accounting costs can miss out on some implicit or hidden costs. The major deficiency of the conventional economic statement is that it does not provide revenues and costs of alternative actions.

EXAMPLE Suppose that you invest Rs.1000 in some shares. You get a return of 20 per cent (Rs.200) annually. One day, you decide to start a small business of your own and sell off your shares and invest your money in your own business. At the end of the year, you find that you have made a profit of Rs.100 - 10 per cent return on your investment.

However, the economic view of the business will be that Rs.100 is being lost annually.

Two representations
Shares Own Business Income 200 100 _____________________________________ Own Business Profit 100 Opportunity Cost of Funds 200 Profit/Loss (-) 100

Why? Because the opportunity cost of the funds is Rs. 200, and this must be subtracted from the profit to give you a correct picture of the viability of your business.

ECONOMIC PROFIT (Added) value from the point of view of the firm: The concept of economic profit
Accounting profit is equal to total revenue minus i explicit costs Economic profit is equal to total revenue minus i all opportunity costs. The opportunity costs consist of both explicit costs and all implicit costs

Therefore, in economics, if we say that a firm is earning zero or negative profits, this does not mean that its accounting profit is zero or negative.

Even a positive accounting profit may hide the true cost of resources being used by the firm.

Profit and Loss Account for ABC Company for the year ending March 31, 2008

If economic profit = 0, then firm is said to earn normal profit: If a firm is to continue operations in an industry, economic rationale demands that it earn revenue at least sufficient to cover the returns from alternative uses of its resources. If economic profit > 0, 0 then the firm is making supernormal profits, and resources are attracted into the industry. If economic profit < 0, the firm can earn more elsewhere, and it would want to exit from the industry.

EVA The aim is to take explicit account of all capital costs.

EVA = Net Operating Profit after Tax (NOPAT) Weighted Average Cost of Capital (WACC).

Suppose there are three types of capital used by a firm K 1, K 2, K 3, and their associated implicit returns are r1, r2 and r3. Then the total cost of capital will be r1K1 + r2K2 + r3K3. This can be written as rK,

WACC is the risk-adjusted cost of both the debt and equity capital and is designed to show the opportunity cost to all the capital suppliers to the firm.

where r = (r1K1 + r2K2 + r3K3)/K, and K = (K1 + K2 + K3).

Company

2002 NOPAT (Rs. Cr.)

2002 WACC (%)

EVA
HLL 1535

2002 Capital Employed (Rs. Cr.)

2002 EVA (Rs. Cr.)

2001 EVA (Rs. Cr.)

Delta EVA (Rs. Cr.)

13.7

3868

1003

765

239

Then r is weighted average return on all the capital employed by the firm that could have been earned elsewhere (in the best possible alternate usages). The total cost of capital, rK, is then called the weighted average cost of capital because of the way we define r.

Infosys

816

23.1

2483

242

224

17

Wipro

854

23.1

2680

235

111

124

Reliance

5115

11.4

47536

-318

328

-646

ITC

1304

13.7

5213

591

420

171

ONGC

6817

12.3

55198

17

-580

596

Source: Business Today, April 13, 2003

Production Possibilities Frontiers and Realworld Trade-offs Production possibilities frontier A curve g the maximum attainable showing combinations of two products that may be produced with available resources.

Production Possibilities Frontiers and Real-world Trade-offs

Graphing the Production Possibilities Frontier
BMWs Production Possibilities Frontier

21 of 21

Drawing a Production Possibilities Frontier for Rosies Boston Bakery

Hours Spent Making Choice A B C D E F Cakes 5 4 3 2 1 0 Pies 0 1 2 3 4 5 Quantity Made Cakes 5 4 3 2 1 0 Pies 0 2 4 6 8 10

Production Possibilities Frontiers and Real-world Trade-offs

Increasing Marginal Opportunity Costs
Increasing Marginal Opportunity Cost