(a) Explain the term opportunity cost. (b) Highlight the relevance of the opportunity cost concept to individuals, firms and government.

Answer Details

(a) Opportunity cost is the real cost of a choice measured in terms of the next best alternative that is given up when that choice is made. Because human wants are unlimited while the resources to satisfy them are scarce, every decision to use resources for one purpose means sacrificing another purpose. For example, if a farmer uses a plot of land to grow maize, the opportunity cost is the yam he could have grown on the same land instead.

(b) Relevance of the concept.

To the individual:

• Consumer spending: a consumer with a limited income must decide what to buy; spending on one good means forgoing another, so he weighs the alternatives to get maximum satisfaction.
• Use of time: a student choosing to attend classes forgoes leisure or paid work, guiding a rational use of scarce time.

To the firm:

• Allocation of resources: a firm decides which product to produce with its limited capital and labour; producing one line means giving up another, so it chooses the most profitable use.
• Investment decisions: funds tied up in one machine cannot be used elsewhere, so the firm compares expected returns of competing projects.

To the government:

• Public spending priorities: with a limited budget, money spent on defence may mean fewer hospitals or schools, so government ranks projects by their benefit to society.
• Planning and taxation: deciding how to use national resources (for example roads versus power) forces a choice among competing development needs.

In every case the concept promotes rational decision-making by making the decision-maker compare what is gained against what is sacrificed.