Opportunity Cost

The opportunity cost of a factor of production is the reward (or value) that factor could have earned in the next best alternative occupation.

In fact, a cost is a forgone opportunity; the cost of engaging in an activity is the totality of all the opportunities that the activity requires you to forgo. To avoid double counting only the best alternative is considered as opportunity cost.

Accounting opportunity costs are important for financial reporting by the firm and for tax purposes. For managerial decision making purposes (with which we are primarily interested in economics) opportunity or economic costs is relevant cost concept.

 With an example of inventory valuation will clarify the distinction.

 Suppose, a firm purchased a raw material for Rs.100/- but its price subsequently rose to Rs.150/-. The accountant would continue to report the cost of the raw material at its original price of Rs.100/-.

The economist however, would value the raw material at its current or replacement value. Failure to do so might lead to the wrong managerial decision.

This would occur, if the firm decides to continue the production using the raw material, while more beneficial outcome would have been to stop output and sell the raw material booking the profit at price Rs.150/-

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By Hassham

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