Opportunity Costs

Definition:
Economics studies

- how choices are made

- from among alternatives
- under conditions of scarcity.
Economics as a discipline exists because
resources are scarce.

Scarcity exists when the necessary resources

for producing the things that people desire are
insufficient to satisfy all wants.

If there were no scarcities, there

would be no need to make choices.
If there are no alternatives
available, then the freedom to choose
has very little meaning.
Choosing a particular alternative
means comparing the benefits and costs
of that alternative.

Opportunity cost
Let
B(Z) be the benefits from choosing
alternative Z,
and C(Z) be the costs of choosing Z.
Then Z should be chosen if B(Z) > C(Z), not
otherwise.
B(Z): maximum rupee amount you would be
willing to pay to do or choose Z.
C(Z): rupee value of the resources you must
give up in order to do Z.

As the definition of C shows, the cost

must be calculated with reference to
the other alternatives that were
forgone.
Definition:
The opportunity cost of an action
refers to the rupee value of the next
best alternative forgone.

Costs are tied to actions, not things.

Even though opportunity costs

include lots of non-monetary costs,
we often monetize opportunity
costs, translating the costs into
rupee terms for comparison
purposes.
Monetizing opportunity costs is
clearly valuable, because it gives a
means of comparison

Pitfall in the Calculation of Opportunity

Costs
Hidden Costs: costs that should be included
but often are not
Some of the costs are implicit and some do
not have any direct monetary valuation.
One might easily overlook them in the
computation of opportunity cost.

EXAMPLE
Arun works as a waiter during weekends and earns
Rs.100.
A couple of his friends are trying to persuade him to go
holidaying with them next weekend.
They will bear the cost of transportation.
However, Arun will have to pay his share of lodging which
will be Rs.50 and also pay Rs.40 as meal charges.
Arun calculates that the opportunity cost of holidaying is
(a) Rs.100.
(c) Rs.90.

(b) Rs.190.
(d) Rs.150.

Accounting costs are derived from

financial reports that mainly categorize
explicit rupee payments.
As a result, accounting costs can miss
out on some implicit or hidden costs.
The major deficiency of the
conventional economic statement is
that it does not provide revenues and
costs of alternative actions.

EXAMPLE
Suppose that you invest Rs.1000 in some
shares.
You get a return of 20 per cent (Rs.200)
annually.
One day, you decide to start a small business of
your own and sell off your shares and invest
your money in your own business.
At the end of the year, you find that you have
made a profit of Rs.100 - 10 per cent return on
your investment.

However, the economic view of the

business will be that Rs.100 is being lost
annually.

Why?
Because the opportunity cost of the funds
is Rs. 200, and this must be subtracted
from the profit to give you a correct picture
of the viability of your business.

Two representations
Shares
Own Business
Income 200
100
_____________________________________
Own Business
Profit
100
Opportunity Cost
of Funds
200
Profit/Loss
(-) 100

ECONOMIC PROFIT
(Added) value from the point of view of the
firm: The concept of economic profit
Accounting profit
is equal
to total revenue
minus
explicit costs

Economic profit
is equal
to total revenue
minus
all opportunity costs.
The opportunity costs consist of
both explicit costs and all implicit
costs

Therefore, in economics, if we say that a firm is

earning zero or negative profits, this does not
mean that its accounting profit is zero or
negative.

Even a positive accounting profit may hide the

true cost of resources being used by the firm.

Profit and Loss Account for ABC Company for the year
ending March 31, 2008

If economic profit = 0, then firm is said to earn

normal profit:
If a firm is to continue operations in an industry,
economic rationale demands that it earn revenue
at least sufficient to cover the returns from
alternative uses of its resources.
If economic profit > 0, then the firm is making
supernormal profits, and resources are attracted
into the industry.
If economic profit < 0, the firm can earn more
elsewhere, and it would want to exit from the
industry.

EVA
The aim is to take explicit account of all
capital costs.
EVA =
Net Operating Profit after Tax (NOPAT)

Weighted Average Cost of Capital (WACC).

WACC is the risk-adjusted cost of both the debt

and equity capital and is designed to show the
opportunity cost to all the capital suppliers to the
firm.

Suppose
there are three types of capital used by a firm
K1, K2, K3,
and their associated implicit returns are
r1, r2 and r3.
Then the total cost of capital will be
r1K1 + r2K2 + r3K3.
This can be written as

rK,

where r = (r1K1 + r2K2 + r3K3)/K,

and K = (K1 + K2 + K3).

EVA
Then r is weighted average return on all the
capital employed by the firm that could have
been earned elsewhere (in the best possible
alternate usages).
The total cost of capital, rK, is then called the
weighted average cost of capital because of the
way we define r.

Company

2002
NOPAT
(Rs. Cr.)

2002
WACC

2002
EVA
(Rs. Cr.)

2001
EVA
(Rs. Cr.)

Delta
EVA
(Rs. Cr.)

(%)

2002
Capital
Employed
(Rs. Cr.)

HLL

1535

13.7

3868

1003

765

239

Infosys

816

23.1

2483

242

224

17

Wipro

854

23.1

2680

235

111

124

Reliance

5115

11.4

47536

-318

328

-646

ITC

1304

13.7

5213

591

420

171

ONGC

6817

12.3

55198

17

-580

596

Source: Business Today, April 13, 2003

10

Production Possibilities Frontiers and Realworld Trade-offs

Production possibilities frontier A curve
showing the maximum attainable
combinations of two products that may be
produced with available resources.

21 of 21

Production Possibilities Frontiers and Real-world

Trade-offs
Graphing the Production Possibilities Frontier
BMWs Production Possibilities
Frontier

11

Drawing a Production Possibilities Frontier

for Rosies Boston Bakery
Hours Spent Making
Choice

Cakes

Pies

Quantity Made
Cakes

Pies

10

Production Possibilities Frontiers and Real-world

Trade-offs
Increasing Marginal Opportunity Costs
Increasing Marginal
Opportunity Cost

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