Opportunity Cost Analysis

Human wants are unlimited and the resource to satisfy the wants are strictly limited is
the basic economic problem. This became a problem because of the following
conflicts. i.e.
1) Individuals want to maximize their satisfaction or pleasure.
2) Firms want to maximize their profit.
3) Governments want to maximize the welfare of the people.

The decision to utilise the scarce resources to produce goods and services to satisfy
maximum wants is known as resources allocation. The allocation of resources is
important for economy or a firm or an individual because of the scarcity of
resources. Scarcity of a thing means that the thing is not available in required
quantity. These scarce resources will have alternative uses.

The decision for Resources allocation of an economy or a firm or an individual is

done based on the following questions
1) What to produce? 2) How to produce?
3) Where to produce? 4) To whom to produce?
The answer for the above questions are considered on the basis of opportunity cost.
Since the wants are unlimited, and the resources to satisfy the wants are limited one
should choose from alternatives. Where Choice means, the selection of some wants
from among a set of different wants. If the initial allocation is not able to economise
the resources so as to maximize satisfaction, profit and the welfare at its proper
desired combination, then the resources are to be reallocated. Reallocation of
resources refers to the withdrawal of resources from unproductive sectors and using
in the productive sectors which gives maximize a desired combination of satisfaction,
profit and the welfare Choice and order of preference. We have to list our unlimited
wants in their order of preferences and choose the most important one. We have to
leave the next best item from our list of preference. In Economics, opportunity
cost [next best alternative forgone] is very important because, the cost of a scarce
resource cannot be calculated in terms of money because it is scarce and it
has alternative uses. So it can only be calculated in terms of the next best alternative
forgone. Alternative means other possibility or option. (There will be either one of
two or one of several, things or courses of action to choose between). For example
“a piece of land” (Scarce resource) could be used for various purposes, i.e. 1) Used
for constructing a school, 2) Used for a children’s park, 3) Used for construction of
an office or 4) Used for building a house.

These are the four alternative uses of that piece of land. To find out the opportunity
cost, make a list of other uses of the land in the order of preference, i.e. 1) a school,
2) a children’s park, 3) an office and 4) a house building. From the list of preferences
if one choose the first option, i.e. a school the opportunity cost of using the land for a
school is the next best alternative from the list of preferences i.e. a children’s park.

Opportunity cost is the next best alternative forgone. The concept of opportunity
cost may be explained using the following diagram.
Opportunity cost concept may be described using a diagram, it is known as
opportunity cost curve. Since it shows the maximum possible production with
existing available resource, it is called as Production possibility curve. This Curve
shows the process of transformation of resources into final products, it is also known
as transformation curve.

The above given diagram shows the different combinations of two commodities that
a country can produce by using it entire resources and technology.
Using all the resources, the economy can produce OA amount of Capital goods or
OB amount of consumer goods. That means if the country produce OA amount of
Capital goods the opportunity cost is OB amount of consumer goods. The next best
alternative forgone to produce OA amount of Capital goods is OB amount of
consumer goods. If the country reduces its production from OA to OP amount of
Capital goods, then the opportunity cost is also reduced from OB to OQ amount of
consumer goods.
Production possibility curve below shows the inefficient attainable and
unattainable combinations of production. The combination of production beyond the
curve is unattainable as shown as point Y and combination of the point below the
curve is an inefficient combination as shown as point X . Different combinations of
production possibilities are on the production possibility curve.
Slope or shape of opportunity cost curve
The production possibilities schedule is illustrated graphically through the slope of
the production possibilities curve. A production possibilities curve or frontier is used
in production economics to indicate how much of each good or service a firm can opt
to produce given that it has limited resources which it has to efficiently allocate
between production of 2 goods.
The slope or shape of the production–possibility frontier (PPF) at any given point is
called the marginal rate of transformation (MRT). The slope defines the rate at which
production of one good can be redirected (by re-allocation of production resources)
into production of the other. It measures how much of good Y is given up for one
more unit of good X or vice versa.
Normally it generates a distinctive convex shape, flat at the top and steep at the
bottom. The convex production possibilities curve shows an increasing opportunity
cost. In this case the economy forgoes increasing amounts of one good when
producing more of the other.
The straight line production possibilities curve that indicates constant opportunity
cost. In this case, opportunity cost does not change with production. Here the
economy forgoes the same amount of one good when producing more of the other.
The concave production possibilities curve shows decreasing opportunity cost. In this
case, opportunity cost actually decreases with greater production. In this case the
economy forgoes decreasing amounts of one good when producing more of the other.
Evaluation of a particular situation with Opportunity cost Analysis is possible only if
a person or a firm or a government confront with a situation with many choices.
A person’s daily life is all about choices;
The following situations explained using diagrams shows the application of
Opportunity cost curve (i.e. Production Possibility Curve).
In our daily life there are many things which illustrate the concept of opportunity
cost.
For example,
(a) staying in tonight to complete homework OR going out for the evening;
(b) saving money for the future OR buying an expensive consumer good.
Other examples are;
Whether staying in tonight to complete homework OR going out for the evening;
Whether saving money for the future OR buying an expensive diamond jewellery;
Whether to get up on time when the alarm goes off OR to sleep a little longer;
Whether to drive to work OR catch public transport;
Whether to have a healthy breakfast at home OR grab a Mc Burger on the way to work. Of

course, all these choices involve implications in terms of opportunity cost.

There are many other things in our country, which apply the concept of opportunity
cost in terms of decisions made by governments, such as building a school
OR buying armaments [ war weapons].

There are many other things with national importance, which apply the concept of
opportunity cost in terms of decisions made by governments, such as building a
school OR buying armaments [ war weapons]. A good contemporary example in
the global economy might be the expenditure of the government on a
military research project when it is still receiving aid from different countries
around the world to help its people. The implications of a particular course of
action can also be explained using a Opportunity cost curve OR Production
Possibility Curve (PPC)
A good contemporary example in the global economy might be the expenditure of
the Chinese government on a space project when it is still receiving aid from
different countries around the world to help its people.
The following situations are explained using diagrams, shows the application of
Opportunity cost.
Increase in capacity of production : A rightward shift of curve shows an increase
in capacity of production either due to a) increase in labour force OR b)
increase in the stock of capital OR c) increase in technology.

Decline in productivity : A leftward shift of curve shows a decline in

productivity either due to a) War OR b) natural disaster