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What Is Opportunity Cost?
Opportunity cost represents the financial cost of business and economic decisions. Since material, financial, and labor resources are all finite, decisions must be made about how to allocate and utilize these resources. Opportunity cost is the cost—or the comparative advantage —of choosing one use over another.
Let’s use a fast-food restaurant as an example. Say this restaurant has seven employees on the morning shift.
- If the manager decides that three of those employees should perform a comprehensive inventory instead of working cash registers, this will slow turnaround time and ultimately lead to decreased sales as lines increase and ward off potential customers.
- Yet inventory is necessary to keep businesses healthy and accountable.
- The difference between the financial impact of three employees performing inventory instead of working on the floor is the opportunity cost.
What Is the Law of Increasing Opportunity Cost?
The law of increasing opportunity cost states that each time the same decision is made in resource allocation, the opportunity cost will increase.
Returning to the fast-food example above, this means:
- The law of increasing opportunity costs states that the opportunity cost of having three employees performing inventory is significant.
- The opportunity cost of having four employees, however, is greater according to the law of increasing opportunity costs.
- If the fast-food restaurant were to then move six of their seven employees to perform inventory, the restaurant operations would halt. It is not possible to run a fast-food restaurant with only one employee working on the floor.
- Each time an additional employee is moved from sales and food prep to back-of-house inventory, the opportunity cost increases.
This gets a bit more complicated when scarce resources under consideration like raw materials and energy, and we try to calculate the profitability of different types of particular finished goods and services on the market.
The tenants of the law are best understood through visualization—economists express increasing opportunity costs on a graph called a Production Possibility Frontier (PPF) or a Production Possibility Curve (PPC). This curve illustrates the various combinations of the quantity of two goods that can be produced using the available resources and technologies. There are several points on the curve, and any point on the arc represents an optimal resource allocation.
Though they represent different production quantities, for example, the difference in favorability from point a to point b is negligible.
Example of Increasing Opportunity Cost
There are many different types of resources and production processes, and for each decision made, there are opportunity costs. And since these decisions are repeated and refined, the law of increasing opportunity costs applies each time production increases by one additional unit (what is known as a marginal cost).
Some examples of increasing opportunity cost are related to factory production. Let’s say a company manufactures leather shoes and leather bags:
- They can spend their resources evenly, spending half their materials and labor on shoe production and half on bags, they can spend their resources entirely on shoe production or entirely on bag production, or any division between these two poles.
- As they move towards one pole or another, their opportunity costs will increase. By making only shoes, they are entirely missing the opportunity to produce and sell bags even though they have the materials, expertise, and market share to do so.
- It is also likely that some of their employees—designers, foremen, etc.—are better suited for one type of production over another. By choosing to only manufacture one, they are not maximizing the resources their employee’s expertise represents.
Why Is the Law of Increasing Opportunity Cost Important in Business?
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The law of increasing opportunity cost is important in business and economics because it describes the perils of moving entirely into nonproduction. There are constant opportunity costs since decisions will always be made about how to best allocate limited resources. Consistently following the same decision or going more extremely towards it will increase opportunity costs.
- Opportunity costs and the law of increasing opportunity costs are illustrated by a production possibility frontier (PPF) or a production possibility curve (never a straight line). This graph considers the factors of production (and assumes full employment), charting the ideal production level of two products competing for the same resources.
- Businesses try to follow the arc of the curve on this graph, understanding that moving too far off its plotted points indicates a maldistribution of resources that will lead to suboptimal economic output.
It is important to note that the PPF is theoretical and that no actual economic decision is made with maximum production efficiency and thus maximum output cannot be assumed. This means that real-world variables such as production costs for the production of goods, the market value of particular consumer goods, and the international trade in United States capital goods and gains from trade.
The principle of increasing costs also applies to personal finance, where people make economic decisions motivated by self-interest to ensure personal profitability. In making certain investment decisions over others, there will be increasing opportunity costs: a marginal return for a marginal increase in investment can be observed through a marginal analysis; these returns are generally governed by the law of increasing opportunity costs.
In making economic decisions in the face of limited resources, there is always a tradeoff as each choice is made. The law of increasing opportunity costs, though not absolute, gives us some guidance to find the best alternative making and analyzing these decisions for a productive economy.
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