The difference between opportunity cost and economic cost lies in their scope and application in decision-making and resource allocation. Opportunity cost is the value of the next best alternative foregone when making a choice; it considers trade-offs. Economic cost consists of explicit costs, which are direct expenses, and implicit costs, which are opportunity costs. Both concepts are important in economics because they help in assessing choices as well as in the efficient use of resources.
What is Opportunity Cost?
Opportunity cost is an important economic idea that shows the value of the next best choice that is given up when a decision is made. It underlines the trade-off involved in using resources, and it focuses on the very best way to use limited resources.
For instance, a farmer looking to either plant wheat or rice may take into account the profit available from both crops. If more profit is realized from planting wheat, then the opportunity cost of planting rice would be the profit lost from not planting wheat.
Key Features of Opportunity Cost
- Alternative Foregone: Opportunity cost always represents the benefit missed from the next best choice not selected.
- Subjective Value: It varies depending on individual preferences, priorities, and available options.
- Application in Decision-Making: Opportunity cost is crucial for evaluating trade-offs in personal, business, or governmental decisions.
- Non-Monetary Aspect: It may include intangible factors like time, satisfaction, or social benefits, in addition to monetary considerations.
Importance of Opportunity Cost
- Helps in Evaluating Trade-offs: Opportunity cost ensures proper decisions by highlighting what is sacrificed when an option is chosen.
- Resource Allocation: It helps in optimizing the usage of scarce resources by finding out potential returns.
- Aids Strategic Planning: Businesses use opportunity cost to compare potential projects or investments.
Calculation of Opportunity Cost
Opportunity cost is calculated by comparing the benefits of the chosen option with the benefits of the next best alternative.
Formula:
Opportunity Cost=Return of Next Best Option−Return of Chosen Option
Example Calculation:
If a person invests ₹10,000 in a savings account yielding 3% annually instead of stocks yielding 7%, the opportunity cost is:
Opportunity Cost=7%−3%=4%
What is Economic Cost?
Economic cost is a broader concept that includes both explicit costs (actual expenses incurred) and implicit costs (opportunity costs). It reflects the total cost of choosing a particular option, encompassing all direct and indirect factors.
Key Features of Economic Cost
- Explicit Costs: Explicit costs refer to tangible, out-of-pocket expenditures, including salaries, rental fees, and materials.
- Implicit Costs: These are often referred to as opportunity costs because they prevent a certain alternative from being available to use by utilizing resources in a certain way.
- A comprehensive measure: Economic cost includes all costs in the decision-making process, particularly relating to non-monetary issues.
- Financial Impacts on Profitability: It calculates the real economic profit including explicit and implicit costs.
Importance of Economic Cost
- Total Costing: The economic cost enables the understanding of the total visible and hidden costs of a decision.
- Strategic Decision-Making: It decides strategically regarding the economic cost of projects or investments made within the organization, which leads to better decision-making.
- Profit Analysis: It depicts the profitability clearly keeping all the expenses in mind, not only the money outgo.
Calculation of Economic Cost
Economic cost is calculated by adding explicit costs to implicit costs.
Formula:
Economic Cost=Explicit Costs+Implicit Costs
Example Calculation: If a business spends ₹50,000 on materials and labor (explicit costs) and forgoes ₹10,000 in rent by using its building (implicit cost), the economic cost is:
Economic Cost= ₹50,000+ ₹10,000= ₹60,000
Key Differences Between Opportunity Cost & Economic Cost
Opportunity cost and economic cost, while closely related, differ significantly in their scope, components, and applications. Below is a more detailed comparison of the difference between opportunity cost and economic cost:
Definition
- Opportunity Cost: The value of the best alternative foregone as a consequence of making a decision. Opportunity cost is essentially a manifestation of trade-off, emphasizing what has to be sacrificed to pursue a given action or investment.
- Economic Cost: Economic cost encompasses the total costs incurred in making a decision, including both explicit costs (direct, monetary expenses) and implicit costs (the value of resources foregone). It provides an important measure of the overall expense involved in pursuing a particular action.
Scope
- Opportunity Cost: Opportunity cost has a narrow scope, as it focuses exclusively on the value of the next best alternative that is not chosen. It is concerned with the trade-offs associated with a specific choice, rather than accounting for all associated expenses.
- Economic Cost: Economic cost has a broader scope, as it considers both explicit costs and implicit costs. It provides a holistic view of the financial impact of a decision.
Components
- Opportunity Cost: Just the value of the foregone alternative. It is a measure of what could have been gained had a different decision been made.
- Economic Cost: It has two primary components. Explicit Costs: The direct, cash payments for something like payments of rent, utilities, or wages. Implicit Costs: The value of a resource used in one specific way as opposed to its best alternative use.
Application
- Opportunity Cost: Opportunity cost is widely used to analyze trade-offs and prioritize decisions. It helps individuals, businesses, and governments assess what they are sacrificing to pursue a particular course of action.
- Economic Cost: Economic cost is essential for a full assessment of the financial impact of decisions. It is commonly used in profit analysis, financial statement analysis, business planning, and investment evaluation.
Calculation Complexity
- Opportunity Cost: Opportunity cost is relatively simple to calculate as it only involves comparing the benefits of two options—the chosen one and the foregone alternative.
- Economic Cost: Economic cost is more complex to calculate, as it requires identifying and quantifying all explicit and implicit costs associated with a decision. It often involves detailed financial analysis and accounting practices.
Impact on Profitability
- Opportunity Cost: Opportunity cost directly influences decision-making but does not appear in accounting records or directly affect a company’s profit calculations.
- Economic Cost: Economic cost directly impacts profitability, as it includes all expenses (both monetary and non-monetary) associated with a decision.
| Aspect | Opportunity Cost | Economic Cost |
| Definition | Value of the best alternative foregone when making a decision. | Total cost including explicit (monetary) and implicit (foregone opportunities) costs. |
| Scope | Narrow: Focuses only on the next best alternative. | Broad: Includes both explicit and implicit costs for a holistic view. |
| Components | Foregone alternative value only. | Explicit costs (e.g., rent, wages) + Implicit costs (e.g., foregone income). |
| Application | Analyzes trade-offs to prioritize decisions. | Used for comprehensive financial analysis and investment evaluation. |
| Calculation Complexity | Simple: Compares benefits of chosen and foregone options, with some subjective judgments. | Complex: Requires quantifying all explicit and implicit costs with detailed financial analysis. |
| Impact on Profitability | Does not appear in accounting but aids in decision-making by assessing unchosen alternatives. | Directly affects profitability by including all costs in economic profit calculations. |
Conclusion
Knowing the difference between opportunity cost and economic cost is important for understanding decision-making in economics. Opportunity cost deals with the value of alternatives given up, which can enable individuals to rank the most valuable alternatives. Economic cost gives a holistic view of all forms of costs so that decisions can be completely understood. The concepts are indispensable in personal, business, and governmental decision-making to guide the efficient allocation of resources and maximize benefits.
Opportunity Cost vs economic Cost FAQs
What is an opportunity cost?
Opportunity cost is the value of the next best alternative given up when a choice is made.
What is an economic cost?
Economic cost is the sum of explicit costs (actual outlays) and implicit cost (opportunity cost).
How does opportunity cost relate to economic cost?
Opportunity cost constitutes part of economic cost since it comprises explicit costs, and it also incorporates the value of the next best alternatives by giving them up in the decision.
Which is wider: opportunity cost or economic cost?
The economic cost is wider as it encompasses explicit and implicit costs, while opportunity cost only talks about the lost alternatives.
Why is opportunity cost important in decision-making?
Opportunity cost emphasizes trade-offs, meaning that individuals and firms can allocate resources efficiently for high returns.
