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Opportunity Cost

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For example:
a) The opportunity cost of the funds employed in ones own business is the interest that could be earned on those funds if they have been employed in other ventures. b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. c) The opportunity cost of holding Rs. 1000 as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs.

Production Possibilities Curve


A production possibilities curve is used to illustrate opportunity cost. The production possibilities curve shows the trade-offs among choices we make.

A Production Possibility Table


A production possibility table lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs.

% of resources devoted to production

% of resources devoted to

Number
of X 0 4

production

of item X
0 20

of item Y
100 80

Qty. of Y 15 14

Row
A B C D

40
60 80 100

7
9 11 12

60
40 20 0

12
9 5 0

E
F

A production possibility curve measures the maximum combination of outputs that can be achieved from a given number of inputs. It slopes downward from left to right. The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost.

The production possibility curve demonstrates that:


There is a limit to what you can achieve, given the existing institutions, resources, and technology. Every choice made has an opportunity costyou can get more of something only by giving up something else.

The production possibility curve is generally bowed outward.


Some resources are better suited for the production of some goods than others.

10 9 8 7 6 .

2Y

If the slope of the production curve is -2 at A, the opportunity cost of 1X is 2Y. A

5
4 3 2 1 0 1 2

1X

10

Why is the production possibility curve is not a straight line?


The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity. In order to get more of something, one must give up ever-increasing quantities of something else.

Any point within the production possibility curve represents inefficiency. Inefficiency getting less output from inputs which, if devoted to some other activity, would produce more output.
Any point outside the production possibility curve represents something unattainable, given present resources and technology.

10
8

Unattainable point, given available technology, resources and labor force Efficient points Inefficient point 2 4 Y C D

6
X 4

B
A

2
0

10

Incremental Principle
It is related to the marginal cost and marginal revenues. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are 1) Incremental cost 2) Incremental Revenue A manger determines the worth of an economic decision on the basis of the criterion that IR>IC.

The incremental principle may be stated as under : A decision is obviously a profitable one if a) it increases revenue more than costs b) it decreases some costs to a greater extent than it increases others c) it increases some revenues more than it decreases others and d) it reduces cost more than revenues