Opportunity cost

The real value of a product or service is the value of other products or services you could buy with the same money.  Opportunity cost is the best alternative we give up when we make a choice.

To Illustrate this, lets say you spend money on only two things, eating out or going to the movies.  For R 2000 you can eat out 10 times, or you can go to the movies 20 times.  The purple area in the graph represents the possible combinations from which you can choose to spend your R 2000.  Every time you eat out, you sacrifice movies. And every time you go to the movies, you sacrifice eating out.

Budget constraint and Oppertunity cost
Budget constraints and opportunity cost

B is not an option, because it falls outside your budget.

The concept of opportunity cost does not only apply to how we spend our money. Most decisions we make involves trade-offs. Do you want to start working after school, or do you want to go studying first and potentially earn a higher entry salary? Do you want to work only half day and spend more time with your kids or do you want to work full day and earn more money which you could spend on your kids education.

Opportunity cost also applies to companies. Should the company use capital to buy equipment or should the company invest the money in a financial instrument? Should the company pay dividends or reinvest in operations? Should the company higher more workers or should they automate using technology.

Opportunity cost also applies to Government. Should government bailout Eskom or should government instead spend money on the new National Health Insurance plan or maybe land reform? Should they increase spending money on grants or should they build more houses?

On a personal noteā€¦ next time we see something we want to buy, we must take a moment to think what we are sacrificing in the process.  We sometimes buy things in the heat of the moment, only to realize later what we should have bought instead.

References

Karl E. Case, Ray C.Fair, Principles of economics.  Seventh Edition, Pearson Prentice Hall, 2004, Chapter 1

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