Opportunity Cost

Meaning

 Sinceresources are limited, every time you

make a choice about how to use them.
Economists use the term opportunity
cost to indicate what must be given up to
obtain something that’s desired.
 A fundamentalprinciple of economics is that
every choice has an opportunity cost.
 Theidea behind opportunity cost is that the cost of
one item is the lost opportunity to do or consume
something else; in short, opportunity cost is the
value of the next best alternative.
Examples

 At the ice cream parlor, you have to choose between

Chocolate and strawberry. When you choose Chocolate,
the opportunity cost is the enjoyment of the strawberry.
 For a farmer choosing to plant corn, the opportunity cost
would be any other crop he may have planted, like wheat
 Rahul decides to quit working and go to school to get
further training. The opportunity cost of this decision is the
lost wages for a year.
Opportunity Cost Formula and Calculation

 Opportunity Cost = FO−CO

 Where : FO=Return on best foregone option
CO=Return on chosen option

 The formula for calculating an opportunity cost is simply the

difference between the expected returns of each option.
 ​
 Thus Opportunity Cost is the value that the
resource would have generated if used in its next
best forgone alternative.
 Opportunity Cost often includes both explicit and
implicit costs.
Time Value of Money

 The time value of money (TVM) is the idea that money

available at the present time is worth more than the same
amount in the future due to its potential earning capacity.
This core principle of finance holds that, provided money
can earn interest, any amount of money is worth more the
sooner it is received.
 Time Value of Money (TVM) is an important concept in
financial management. It can be used to compare
investment alternatives and to solve problems involving
loans, leases, savings.
 TVM help us in knowing the value of money invested. As
time changes value of money invested on any project/ firm
also changes. And its present value is calculated by using
“mathematical formula”, which tell us the value of money
with respect of time. i.e.
Reason for Time value of Money

 There are certain reason which determine

that money has time value following are the
reason;
 1. Risk and Uncertainty
 2. Inflation
 Consumption
 Investment opportunities
Importance of TVM

 1. In Investment Decisions - Small businesses often have

limited resources to invest in business operations, activities
and expansion.
 2. In Capital Budgeting Decisions - When a business
chooses to invest money in a project - such as an
expansion, it may be years before that project begins
producing a positive cash flow. The business needs to
know whether those future cash flows are worth the upfront
investment
Techniques of time value of money

 There are two techniques for adjusting time value

of money. They are:
 1.Compounding Techniques/Future Value
Techniques
 2. Discounting/Present Value Techniques
Marginalism

 Case study

 Why Repairmen Earn More Than Child-Care Workers

 David R. Henderson
 Child-care workers perform important work. The total utility
of their work is probably much higher than the total utility of
the work performed by workers who repair air conditioners.
So why do air-conditioning repairmen earn more than child-
care workers?
 Marginalism has the answer. Suppose there are fewer
children and more air conditioners than there used to be.
Suppose also that for the same wage there is a surplus of
child-care workers and a shortage of people who repair air
conditioners. Then the wage cannot be the same. If it were,
the only way to get enough air-conditioning repairmen
would be to conscript them.
 So the only peaceful way to get the right number of
child-care workers and the right number of air-
conditioning workers is to let the market work. This
means letting the higher SUPPLY of child-care
workers drive down their wage and the lower
supply of air-conditioning repairmen drive up their
wage.
 Although the total utility of work performed by
child-care workers exceeds the total utility of work
performed by air-conditioning repairmen, the
marginal value of the latter’s utility exceeds the
marginal value of the former’s.
 ADAM SMITH
struggled with what came to be called the paradox of “value
in use” versus “value in exchange.” Water is necessary to
existence and of enormous value in use; diamonds are
frivolous and clearly not essential. But the price of
diamonds—their value in exchange—is far higher than that
of water.
 The marginalist explanation is as follows: The total utility or
satisfaction of water exceeds that of diamonds. We would
all rather do without diamonds than without water. But
almost all of us would prefer to win a prize of a diamond
rather than an additional bucket of water. To make this last
choice, we ask ourselves not whether diamonds or water
give more satisfaction in total, but whether one more
diamond gives greater additional satisfaction than one more
bucket of water. For this marginal utility question, our
answer will depend on how much of each we already have.
 Fordeciding whether an additional unit of labor or
capital should be employed or not, the manager
needs to know the additional output expected
therefrom. As long as additional output (or return)
exceeds the cost of additional unit of labor (or
capital), it is worthwhile to employee that unit.
 The
firm should continue to produce the
commodity as long as marginal revenue exceeds
marginal cost. Profits are maximized at the point
where marginal revenue is equal to marginal cost.
 Marginal revenue is defined as the amount of
money received by selling another (marginal) unit
of the commodity. For instance, if n units of a good
are sold, then the marginal revenue of the nth unit
is defined as:
 MRn = TRn – TRn – 1
 In a similar way, marginal cost of nth unit will be:
MCn = TCn – TCn – 1
 As long as the revenue obtained by selling the
marginal unit is greater than the cost incurred in
producing it (i.e., as long as MR exceeds MC), the
firm generates profit
Incrementalism

 The concept of ‘incrementalism’ is basic in undertaking

business decisions. It is similar to ‘Marginalism’ but with a
difference. In the discussion above, it was stated that the
‘marginal’ concept is associated with ‘a unit’ change.
However, in most of the cases, business firms produce and
sell their products in bulk and not in units. Therefore, the
business firms take their decisions on the basis of
incremental revenue and incremental cost and not on the
basis of marginal revenue and marginal cost.
 What incremental cost and incremental revenue is:
 Incremental cost is defined as the change in total cost that
arises due to business decision (i.e., as a result of a
change in the level of output, investment, etc.).
 Incremental revenue is defined as the change in total
revenue that arises due to a business decision (i.e., as a
result of a change in the level of output, investment, etc.)
 Correct incremental analysis requires that all direct and
indirect changes in revenue and costs resulting from a
particular course of action be taken into consideration. The
business decision rule would be as follows:
 The firm should change the price of a product or its
output, introduce a new product, or a new version
of a given product, accept a new order, etc., if the
increase in total revenue or incremental revenue
from the action exceeds the increase in total or
incremental cost.
 To illustrate, let us suppose that a business firm
receives an order for the supply of 50 additional
units of its product. Let us suppose that meeting
this order would add to cost of production by ` 10
lakh (` 3 lakh in terms of labor cost, ` 5 lakh in
terms of marginal cost and ` 2 lakh in terms of
overhead cost). In other words, the incremental
cost is ` 10 lakh. If the additional production is
expected to increase the total revenue of the firm
by ` 12 lakh, the incremental revenue would be `
12 lakh. Since in this case, expected incremental
revenue exceeds incremental cost, the firm should
accept the order.