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3. Explain the following concepts with suitable example.
Opportunity cost refers to highest
valued alternative forgone whenever a choice is made. It
is the loss of potential gain from other alternatives when one particular
alternative is chosen over the others.
As a
representation of the relationship between scarcity and choice, the
objective of opportunity cost is to ensure efficient use of scarce resources.
It incorporates all associated costs of a decision, both explicit and
implicit. Opportunity cost also includes the utility or economic benefit
an individual lost; it is indeed more than the monetary payment or actions
taken. As an example, to go for a walk may not have any financial costs
imbedded to it. Yet, the opportunity forgone is the time spent walking which
could have been used instead for other purposes such as earning an income. Concept
of opportunity cost can be well understood with the help of following example-
Mr. X
is the owner of a small grocery store in a busy section of Mumbai. Adam’s
annual revenue is Rs. 20, 00,000 and his total explicit cost (Adam pays himself
an annual salary of $3, 00,000) is Rs.15,00,000 per year. A supermarket chain
wants to hire Adam as its general manager for Rs. 6, 00,000 per year. In this
case, the opportunity cost to Mr. X of owning and managing the grocery store is
the Rs.6,00,000 in forgone salary that he might have earned had he decided to
work as general manager for the supermarket chain.
Opportunity cost can be
of two types-
Sometimes referred to as
out-of-pocket expenses, explicit costs are “visible” in the sense that they are
direct payments for factors of production. Explicit costs are visible
expenditures associated with the procurement of the services of a factor of
production Operation and maintenance costs such as Wages paid to workers, overhead, materials and rental payments, Land and infrastructure costs are examples of explicit costs.
For
instance, if a person leaves work for an hour and spends Rs. 200 on office
supplies, then the explicit costs for the individual equates to the total
expenses for the office supplies of Rs. 200. If a printer of a company
malfunctions, then the explicit costs for the company equates to the total
amount to be paid to the repair technician.
Implicit costs are
“invisible” in the sense that no direct monetary payments are involved. They
are the value of any forgone opportunities. Implicit costs, however, may be
made explicit. Implicit costs represent the
value of resources used in the production process for which no direct payment
is made. This value is generally taken to be the money earnings of resources in
their next best alternative employment. When a computer software programmer
quits his or her job to open a consulting firm, the forgone salary is an
example of an implicit cost. When the owner of an office building decides to
open a hobby shop, the forgone rental income from that store is an example of
an implicit cost. When a housewife decides to redeem a certificate of deposit
to establish a day-care center for children, the forgone interest earnings
represent an implicit cost. Examples of implicit costs regarding production are
mainly resources contributed by a business owner which includes human labour, Infrastructure
and time
Significance of Opportunity Cost
Opportunity cost is an
inevitable part of any business activity since it triggers the process of
decision making. Major reasons for which any business needs to determine the
opportunity cost are as follows:
Opportunity cost
provides support for making an appropriate choice while selecting one out of
many available alternatives.
Based on the expenses
incurred in the procurement of any goods or services along with the cost which
may have been committed to acquiring alternative options, the price of the
products or services is determined.
·
Efficient
Resource Allocation
It helps in investing
the resources in the right opportunity by analysing the opportunity cost of all
the alternatives.
In organisations, it
played a crucial role in determining the expected value an employee would
create for the organisation. It is acquired after his/her comparison to the
other alternatives available, and thus, personnel remuneration is considered
accordingly.
According to
this principle, if a decision affects costs and revenues in long-run, all those
costs and revenues must be discounted to present values before valid comparison
of alternatives is possible. This is essential because a rupee worth of money
at a future date is not worth a rupee today. Money actually has time value.
Discounting can be defined as a process used to transform future dollars into
an equivalent number of present dollars.
Since future is
unknown and incalculable, there is lot of risk and uncertainty in future.
Everyone knows that a rupee today is worth more than a rupee will be two years
from now. This appears similar to the saying that “a bird in hand is more worth
than two in the bush.” This judgment is made not on account of the uncertainty
surrounding the future or the risk of inflation.
It is simply
that in the intervening period a sum of money can earn a return which is ruled
out if the same sum is available only at the end of the period. In technical
parlance, it is said that the present value of one rupee available at the end
of two years is the present value of one rupee available today. The
mathematical technique for adjusting for the time value of money and computing
present value is called ‘discounting’.
The following
example would make this point clear. Suppose, we are offered a choice of Rs.
1,000 today or Rs. 1,000 next year. Naturally, we will select Rs. 1,000 today.
That is true because future is uncertain. Let us assume we can earn 10 per cent
interest during a year. We would be indifferent between Rs. 1,000 today and Rs.
1,100 next year i.e., Rs. 1,100 has the present worth of Rs. 1,000. Therefore,
for making a decision in regard to any investment which will yield a return
over a period of time, it is advisable to find out its ‘net present worth’.
Unless these returns are discounted and the present value of returns
calculated, it is not possible to judge whether or not the cost of undertaking
the investment today is worth.
The concept of
discounting is found most useful in managerial economics in decision problems
pertaining to investment planning or capital budgeting. Discount rates are used
to compress a stream of future benefits and costs into a single present value
amount. Thus, present value is the value today of a stream of payments,
receipts, or costs occurring over time, as discounted through the use of an
interest rate. Present value calculations of benefits and costs are then
compared to determine benefit-cost ratios. For example, if the present value of
all discounted future benefits of a restoration project is equal to $30 million
and the discounted present value of project costs totals $20 million, the
benefit-cost ratio would be 1.5 ($30 million / $20 million), and the net
benefit would be $10 million ($30 million — $20million). Any benefit-cost ratio
in excess of 1.0 or net benefit above 0.0 demonstrates positive economic
returns to society. Note that values used for benefit-cost analysis are often
amortized over the project time horizon, yielding annualized benefits and
costs. This practice allows for comparison of projects with different
timeframes. The formula of computing the present value is given below:
V = A/1+i
where:
V = Present
value
A = Amount
invested suppose Rs. 100
i = Rate of
interest supposed to be 5 per cent
V = 100/1+.05 =
100/1.05 =Rs. 95.24
Similarly, the
present value of Rs. 100 which will be discounted at the end of 2 years:
A 2 years V =
A/ (1+i) 2
= 100/ 1.052
= Rs. 90.70
For n years V =
A/ (1+i) n
Discounting
reflects how individuals value economic resources. Empirical evidence suggests
that humans’ value immediate or near-term resources at higher levels than those
acquired in the distant future. Thus,
discounting has been introduced to address the issues raised by the existence
of this phenomenon, which is known as time preference. Time preference is of
significant interest to economists but the weight it is given depends on the
discount rates used to perform present-value calculations.
Inflation is a
primary reason for discounting; however, independent of inflation, discounting
is an important tool for assessing environmental benefit streams. Discount
rates also reflect the opportunity cost of capital. The opportunity cost of
capital is the expected financial return forgone by investing in a project
rather than in comparable financial securities. For example, if Rs.10 is
invested today in the private capital markets and earns an annual real rate of
return of 10 percent, the initial Rs.10 investment would be valued at Rs. 25.94
at the end of 10 years. Therefore, discount rates reflect the forgone interest
earning potential of the capital invested in the public project.
