Opportunity cost

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Definition

Opportunity cost is one of the most basic concepts in economics. A fundamental rule in economics is ―never do anything unless it is worth more than its opportunity cost‖. Opportunity cost expresses the idea that for every choice, the true economic cost is the sacrifice of the next best opportunity. Or, in other words, the opportunity cost is the net benefit forgone because the resource providing the service can no longer be used in its next-most-beneficial use. As an example, suppose a farmer cuts down a forest to expand his cropland. If the consequent loss of timber, firewood, and water purification function is the next best use of the land, then the value of timber, firewood, and water purification is the opportunity cost of the expanded cropland. Another example would be the choice to use a particular section of a river either for canoeing or to generate electric power. Since the dam needed to generate power would flood the rapids, the two uses are incompatible. The opportunity cost of producing power is the foregone net benefit of canoeing.

Opportunity cost and resource scarcity

The concept of opportunity cost is linked to the notion of scarcity of resources. Indeed, the economic system has a certain endowment of relatively scarce resources (land, industrial machinery, raw materials, labour). Each use implies an opportunity cost from using the resource for one use rather than for another competing one. If someone chooses to spend time resting rather than making a bookshelf, the opportunity cost is the value of that bookshelf that might have been produced. Time is the scarce resource; using it to rest entails a clear loss of opportunity for shelf-making. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit should also be considered as opportunity costs. It can also be used to measure the economic effect of the rising scarcity of a natural resource by computing how much a society must give up to obtain an additional unit of the resource. Moreover, differences in resource quality affect the economy through the opportunity cost. Opportunity cost is equal to the goods and services that cannot be produced because energy is used to produce an alternative good or service. For example, energy used to harvest timber cannot be used to heat a home.

Uses

The opportunity cost approach is a very useful technique when benefits of certain uses, such as preservation, protection of habitats, cultural or historical sites, cannot be directly evaluated. For example, the cost of preserving forests for a national park rather than harvesting them for timber would be assessed by using the forgone income from selling timber. Similarly, in the Yasuni ITT proposal in Ecuador in 2007, the government was ready to forego the revenue from the extraction of 850 million barrels of oil (taking into account the benefits from conservation of biodiversity, the rights on the indigenous population, and the carbon dioxide emissions avoided), but the government asked for external contributions from other countries to cover half the ―opportunity cost‖ (that is, half the foregone revenues that would be obtained by extracting and selling the oil).

Issues

In this way opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. It has been described as expressing "the basic relationship between scarcity and choice." However, we must point out that difficulties in assessing the benefits from environmental preservation can lead to the inefficient allocation of resources. The concept of opportunity cost is also at the heart of a debate between standard (environmental) economics and ecological economics in the way they see the world. While the former sees the economy as the whole, drawing from nature or the environment as sectors of the macroeconomy (forests, fisheries, grassland, mines, wells, ecotourist sites, and so on), the latter envisions the (macro) economy as a part of a whole, namely the earth, its ecosystems and its atmosphere, within a finite, non-growing and materially closed ecosystem. Starting from this point, if the economy grew in a void (as it does according to standard economics), it would encroach on nothing and its growth would have no opportunity cost so that it could expand without limit. But since the economy grows into a finite ecosystem, the growth of the macroeconomy overlaps onto the non-growing whole, implying a sacrifice of something (the opportunity cost). Thus growth does have a cost and, at some point the continued growth of the macroeconomy will cost us more than it is worth. This is what is referred to (in Herman Daly‘s words) as uneconomic growth. In a situation where the economy was very small relative to the ecosystem (as in pre-industrial times), there would be no need to stop growing since resources would be abundant and the opportunity cost for economic expansion would be insignificant. But in the long run, with continued growth, we would arrive at state in which the opportunity cost of growth was significant. According to many ecological economists and advocates of sustainable economic degrowth, we are already in such a situation.

References

  • H. E. Daly, 2007, Ecological Economics and Sustainable Development, Selected Essays of Herman Daly, Northampton MA: Edward Elgar Publishing.
  • T. M. Crowards, 1998, Safe Minimum Standards: Costs and Opportunities, Ecological Economics, vol. 25 (3), pp. 303-314.
  • James M. Buchanan, 1987, Opportunity Cost, The New Palgrave: A Dictionary of Economics, vol. 3, pp. 718–21.

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