When we decide to use our resources (or money) in some way, it necessarily involves us foregoing, or giving up, the opportunity to use those same resources (or money) in some other way.  This is because resources (or factors of production) are relatively scarce and have alternative ways of being used.  

Accordingly, the opportunity cost of decision making can be defined as the value (or net benefit) that could have been derived if the next best alternative/option was chosen.  For example, most governments have substantial (but limited) funds at their disposal to use for society’s benefit.  If the government chooses to spend $1b on support to local industries in an effort to protect jobs, it foregoes or sacrifices the opportunity to use that same $1b for investment in health, education or renewable energies.  The opportunity cost in this example is the benefit(s) that could have been derived from the investment in either health, education or renewable energies, whichever was considered the next best option for the government.

As economic agents, we make decisions every day that involve opportunity costs and the best (or most efficient) economic decisions will be those that minimise opportunity costs.  In other words, there is no superior or better way of using our resources for any given decision.  This means that any rational (economic) decision will necessarily be one where the anticipated net benefits/rewards are the highest and/or the net costs are lowest.  Of course, this assumes that our decisions are always rational.  In reality, economic agents (including governments) occasionally make irrational decisions that inevitably result in unnecessarily high (opportunity) costs. For governments, this relates to unintended consequences of government decisions and/or government failure.

To illustrate the concept of opportunity cost, we will assume that a farmer with 1000 acres of land has conducted extensive research and determined that his or her land will yield the following benefits in dollar terms:

  1. $100,000 of annual income if used for banana production;
  2. $80,000 if used for guava production; and
  3. $60,000 if used for pineapple production. 

If the farmer is purely motivated by profit, the rational decision would be to use the land for banana production, with the opportunity cost being the $80,000 of guava revenue that will be sacrificed.  The decision is rational because the $100,000 of revenue gained from producing bananas will be greater than the $80,000 of revenue that would have been gained if the farmer used the land for guava production.  

However, assume now that the farmer decided to use the land for guava production and expects to receive $80,000 per year.  This is clearly an irrational decision for a farmer who is solely motivated by profit.  The opportunity cost of guava production is now the $100,000 of revenue that has been sacrificed.  In this case, the farmer has not minimised opportunity costs because the opportunity cost of the decision is $100,000 (the money that could have been earned from the “next best alternative”) when it could have been $80,000.

While this clip endures for more than 8 minutes, if you are pushed for time, then watch it to the 3:30 mark!  This will be enough to consolidate your understanding of ‘opportunity cost’.