Case Scenario:
Opportunity Cost
Opportunity cost is a key concept in economics that affects the decisions you make in your personal and professional life. Opportunity cost is the value of a resource in its next best use. For some, this definition may be hard to understand, so with the following is a universal illustration of the concept.
For many people, their most valued resource is time. Time is finite for everyone; there are only twenty-four hours in each day for work, family, sleep, fun, and other activities. Many activities are mutually exclusive. Once you have decided to do one activity, you have inherently decided not to do another. If you decide to go to a movie, those two hours are not spent at the gym. In addition to the cost of the movie, you have foregone the benefits of two hours of exercise. The true cost of the movie is not just the price of the movie ticket, but the value of exercising at the gym. Although the value of the exercise may be more difficult to quantify than the price of the movie ticket, you must consider it when you decide how to spend your time.
Consider another example: Suppose you live outside an urban area, such as New York City, where commuter trains offer an alternative to driving to work. How would you make the decision whether to take the train or drive? Most people would compare the out-of-pocket costs of driving to riding. Provided the costs of car ownership (including depreciation) and operation (gasoline, maintenance, and parking), the train may be cheaper. But you should also add the value of your time. Driving requires your undivided attention. If you are on the train, what could you do with your commute time? You might devote it to getting work done, which could benefit your career or free up some time to spend with family and friends; you could sleep on the train or study for an advanced degree through a college or university that makes the learning materials available digitally. In this particular case, the value of the commute time on the train, as opposed to driving, is the return on the educational investment through promotions and a higher income. When comparing the out-of-pocket costs of the drive versus train decision, you need to remember the value of the time that the commute provides.
One reality that underlies the concept of opportunity cost is that at any given moment, resources are fixed. If you have to make a decision right now, you have a fixed amount of time, labor, materials, and capacity with which to work. If you decide to use resources (time, people, materials, or capacity) for one application, you exclude using them in another way. If that other way has some value, you need to recognize the value as an opportunity cost that could affect the decision. This is best illustrated with the following business example.
Suppose your organization is making two types of calculators, a basic model (BASIC) and a more feature-laden model (FEATURES). The company charges more for FEATURES. The cost to produce FEATURES is higher, but so are the profits. Imagine that your factory is producing both models of nearly all the calculators it can by running all the shifts. You must decide whether to redeploy resources from one model to make the other one. An additional 50 calculators can be produced, if needed. The following data sets the stage for our decision.
Table:
Price, Costs, and Profits for BASIC and FEATURES
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BASIC model
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FEATURES model
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Price per unit
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$10.00
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$15.00
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Variable costs
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$4.00
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$5.00
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Fixed overhead allocation
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$5.00
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$6.00
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Profit
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$1.00
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$4.00
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The variable costs reflect the wages and benefits paid to the people making the calculators, the materials that go into production, and anything else (like electricity) that is paid for to make the calculator. If calculators are not made, these direct or variable costs may be saved; however, other costs in a factory must be covered even if production is temporarily stopped. Taxes, insurance, and supervisory and management personnel are fixed, or overhead, costs that in the short term do not go away if calculator production is stopped. Typically, these costs are allocated to the products that the factory makes. The price of the calculators must cover both the variable and fixed (overhead) costs before the company can realize a profit. So, in the example, producing BASIC units incurs costs of $9.00 per unit by including both the variable costs ($4.00) and fixed or overhead costs ($5.00), leaving a profit of $1.00 per unit. Similarly, FEATURES units cost more to make ($5.00 for variable costs plus an allocated overhead of $6.00 per unit) but, because the company can charge more for the fancier calculators, they earn a profit of $4.00 per unit. Although you can decide to shift production between BASIC and FEATURES, you discover that each one has an opportunity value, particularly as it contributes to the factory’s profits and fixed overhead. This is the opportunity cost of each of the calculators.
Consider a situation a factory manager might experience: Suppose the marketing department calls with a great offer from a customer who wants to order 100 BASIC calculators. Should the factory manager accept the order? Remember that the factory is operating nearly at capacity, but could meet half the order (50) with the little bit of idle capacity at the factory. How will accepting the order for 100 calculators affect profits? First, it generates revenue of $1,000 (100 BASIC calculators @ $10 each). Next, it incurs variable costs of $4.00 per unit produced ($400). Would the profit on the order be $600, because all of the fixed costs have already been allocated to existing production? Not quite.
The manager needs to recognize that, to fill the order for 100 calculators, the factory must redeploy production of 50 FEATURES calculators to make 50 BASIC calculators beyond capacity. What are the implications of this? First, the company was making $4.00 profit on each FEATURES calculator and by stopping production of 50 FEATURES calculators, they forego $200 of profit. The $600 of anticipated profit on the new order has been trimmed to $400. Is that all? No, by suspending production of 50 FEATURES calculators, these no longer contribute to the fixed overhead, which was $6.00 per unit. By not producing 50 FEATURES calculators, production does not cover $300 of overhead. That trims anticipated profits to $100, which is the true contribution to profits of taking on the new order. This is summarized in the following table.
Table: Contribution Analysis of Calculator Opportunity
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Incremental Revenues [a] $1000
Less Incremental Costs [b] $400
Less Opportunity Costs [c] $500
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[a] 100 units of BASIC @ $10 a unit
[b] 100 units @ $4 a unit
[c] Contribution to profit ($4) and overhead ($6) foregone by producing 50 fewer FEATURES calculators; 50 units @ $10 a unit
The opportunity cost of the factory and its resources is its worth in its next best use. From the perspective of producing the BASIC calculator, the next best use is making a FEATURES calculator. The manager must consider as foregone value both the profits and the contribution to overhead that would be missed if some of the production for FEATURES were redeployed to BASIC calculators.
As the example illustrates, economics defines profits as revenues less economic costs, which include both the incremental or out-of-pocket costs, as well as the opportunity costs of displaced resources used if the decision is made. Although this may vary from accounting profits, the example here illustrates that when making a sound business decision, it is worthwhile to include the value of resources in the next best use, or opportunity costs.
Question 1)
a) Among the types of costs faced by a firm (short-run costs, fixed and variable, as well as long-run costs), how can technology and/or outsourcing help firms to lower their costs?
b) What are some specific examples of how your workplace has used technology and/or outsourcing to lower costs? Note: If your workplace has not used technology to lower costs or if this is proprietary information, then discuss a workplace that has.
Question 2)
a) In a purely competitive market, all firms face the same price for the goods or services they sell. Would you expect all firms that sell identical goods or services in a purely competitive market to earn the same amount of profit? Why or why not?
b) What could a firm do to earn an economic profit if it finds itself in a purely competitive industry selling a commodity?
c) Do firms in the industry in which your workplace operates earn economic profits? Why or why not? Note: If your workplace is not a for-profit, private-sector firm, then choose a for-profit, private-sector firm to answer this part of the question.
Question 3) Explain profit maximization principles in a purely competitive market and provide real world examples or professional experiences.