Opportunity cost is a central
concept of microeconomics. A focus on opportunity cost rather than measures of
accounting cost is a central characteristic of economic reasoning.
History
The concept of opportunity cost was developed in the early 20th century by
Friedrich von Wieser[1], though it is implicit in the works of earlier writers
such as Manger.
Example
For example, if a city decides to build a hospital on vacant land it owns, the
opportunity cost is the value of the benefits forgone of some other thing which
might have been done with the land and construction funds instead. In building
the hospital, the city has forgone the opportunity to build a sporting center on
that land, or a parking lot, or the ability to sell the land to reduce the
city's debt, since those uses tend to be mutually exclusive. Also included in
the opportunity cost would be what investments or purchases the private sector
would have voluntarily made if it were not taxed to build the hospital. The
total opportunity costs of such an action can never be known with certainty (and
are sometimes called "hidden costs" or "hidden losses", what has been prevented
from being produced cannot be seen or known). Even the possibility of inaction
is a lost opportunity (in this example, to preserve the scenery as-is for
neighboring areas, perhaps including areas that it itself owns).
Evaluating opportunity cost
Opportunity cost need not be assessed in monetary terms, but rather can be
assessed in terms of anything which is of value to the person or persons doing
the assessing (or those affected by the outcome). For example, a person who
chooses to watch, or to record, a television program cannot watch (or record)
any other at the same time. (The rule still applies if the recording device can
simultaneously record multiple programs; there is going to be a limit, and if
the number of desired programs exceeds the capacity of the recorder, some of
them will not be saved, and thus cannot be seen.) In any case, at the time the
person chooses to watch a program, either live or on a recording, they cannot
watch something else, and if they are not able to record another program showing
at the same time, the opportunity to view it is lost (presuming the particular
program is not repeated). Or as another example, someone having a video game can
choose to watch a program or play the video game on the TV; they can't do both
simultaneously. Whichever one they choose is a lost opportunity to experience
the other. Or for that matter, a lost opportunity to engage in some other
activity entirely (exercising outdoors, or visiting with family or friends, as
merely two examples).
The consideration of opportunity costs is one of the key differences between the
concepts of economic cost and accounting cost. Assessing opportunity costs is
fundamental to assessing the true cost of any course of action. In the case
where there is no explicit accounting or monetary cost (price) attached to a
course of action, ignoring opportunity costs may produce the illusion that its
benefits cost nothing at all. The unseen opportunity costs then become the
implicit hidden costs of that course of action.
Note that opportunity cost is not the SBC sum of the available alternatives, but
rather of benefit of the best alternative of them. The opportunity cost of the
city's decision to build the hospital on its vacant land is the loss of the land
for a sporting center, or the inability to use the land for a parking lot, or
the money which could have been made from selling the land, or the loss of any
of the various other possible uses -- but not all of these in aggregate, because
the land cannot be used for more than one of these purposes.
However, most opportunities are difficult to compare. Opportunity cost has been
seen as the foundation of the marginal theory of value as well as the theory of
time and money.
In some cases it may be possible to have more of everything by making different
choices; for instance, when an economy is within its production possibility
frontier. In microeconomic models this is unusual, because individuals are
assumed to maximize utility, but it is a feature of Keynesian macroeconomics. In
these circumstances opportunity cost is a less useful concept.