The concept of scarcity tells us that we cannot have everything we want because resources are scarce.
The concept of opportunity cost tells us that there is a trade off. The opportunity cost is the giving up of next best alternative use for a resource.
For example, we have a hundred dollars. We can invest the hundred dollars in mutual fund. We can use the hundred dollars to buy grocery. We can donate the hundred dollars to charity. We can use the hundred dollars in many other ways.
When we narrow down the use of the hundred dollars to two choices, we make it easier to make a decision. We can choose to invest the dollars in mutual fund or buy grocery. Let us assume that we use the hundred dollars to buy grocery. The opportunity cost of the grocery is mutual fund investment.
Once we use the hundred dollars to buy grocery, we forgo the chance of investing in mutual fund.
The concept of opportunity cost is the central theme of the study of Economics.
We see people make decisions every day. We see the governments make decision every day. Every decision has an opportunity cost.
When a student has to choose between work and attend the lecture in the afternoon, he is evaluating the opportunity cost. Since he cannot work part time and attend the lecture in the same afternoon, he has to make a choice. Let us assume that he chooses to work instead of class. The opportunity cost of work is the lecture.
Another student may make a different choice. The opportunity cost is different. The opportunity cost will depend on what we have to give up by our decision. The opportunity cost differs from person to person.
Some people choose to sleep and miss work. Ultimately, the opportunity cost of sleeping more is the job. That is a very high cost to pay for a few hours of sleep.
In some cases, the opportunity cost is computed mathematically. When you have two job offers, you can compute the opportunity cost in the monetary sense. Let us assume that company A offers you a salary of $2,000. Your total transportation expenses for going to work costs $200. Company B offers you a salary of $1,900. You can walk to work, and save time and money on travelling. It is not that hard to make a choice when you can compute the opportunity cost mathematically.
On a national level, the opportunity cost is higher. When the government decides on land use, it has to consider the opportunity cost. No government will allocate a piece of land for farming in the prime area of the city. It is stupid to let farming takes place in the most expensive land in the country.
The concept of opportunity cost is the central theme of Economics and Finance. The concept of opportunity cost helps us to improve decision-making skill. Do ask yourself: what is the opportunity cost of making a choice?
Source: Macroeconomics Demystified by August Swanenberg (ISBN:0-07-145511-6)