The importance of opportunity cost

In economics, there are three questions regarding scarcity: What is scarce? How do we overcome scarcity and produce more? And who is the scarce product for?

Remember, there is only a finite quantity of resources to satisfy wants, which is known as scarcity. This implies that there has to be a choice regarding utilising a resource. This trade-off can be between a number of different choices. How do you decide which choice to make?

An example could be deciding where you’re going to spend a holiday. You need to decide what holiday you want, how you’re going to trade resources to obtain your holiday, and who will provide you your holiday. Do you want sun, sea and sand? Or culture, history and great views? Or should you utilise your holiday by decorating your home? How are you finding the resources you’re allocating? Most of the resources revolve around the availability of your time and money. You’re making a number of choices, and the deciding factor is whatever is the next best alternative use of the resources being used for the holiday.

This method of allocating scarce resources is referred to as opportunity cost (Beveridge, 2013, p. 4). This is a key microeconomic theory used to explain how choices are made regarding the allocation of scarce resources. A definition of opportunity cost is the cost of the next best alternative that is given up. Let’s look at an example to help explain this concept.

You’ve recently been gifted a three-year-old camper van with low miles and in good condition. What are you going to do with a camper van? You could sell it for cash, say for £5,000, and then buy something you want or put the money into a bank account. You could go on a road trip and save yourself the cost of hotel rooms, which might amount to £2,000 for two weeks of hotel stays. Or you could start a business, renting your camper van to others who want to go on a touring holiday, earning £1,000 over every two-week period the camper van is rented out.

Each of these alternatives has a cost: £5,000 to sell, £2,000 hotel savings or £1,000 earnings. If you take the option of selling the camper van, the second choice of £2,000 hotel savings is lost, and this loss is known as the opportunity cost. This example highlights the trade-offs between the different uses of the resource, which helps in the resource allocation.

References

_{Beveridge, T. (2013). A Primer on Microeconomics. Business Expert Press. https://locate.coventry.ac.uk/permalink/f/gr8698/COV_ALMA5183238700002011}