When an economic choice is made, economists measure the cost of that
choice in terms of opportunity cost, which is defined as the value of the
best alternative forgone.
Self-employment provides an interesting example of opportunity cost.
Suppose that you start a software firm. You rent office space, hire
programmers, and sell software. Suppose that after one year, all of your
direct costs can be listed as follows:
Office rent: US$12,000 Salaries : US$24,000 Utilities : US$10,000
Total costs for the year are US$46,000. Also suppose that your software
sales were US$48,000. You might be very happy with US$2,000 profit!
However, the accounting profit that we just calculated is not the relevant
measure of your success. Suppose that you could have worked for an
international bank and earned US$8,000. Your forgone opportunity to earn
US$8,000 is your opportunity cost. You have earned an economic loss of
US$6,000.
Another example concerns a university that wanted to expand, and which
owned some land in a large city. One university official said that since the
university already owned the land, it was "free." In fact, the land was not
"free" because it had alternative uses. It could, for example, be sold and the
money used to build on cheaper land.
Opportunity cost is a useful concept for thinking about government
activity. When government subsidizes some industry, the opportunity cost
is the value of best alternative use for the money, such as education or
health.
The next article discusses how a market economy determines prices and
ensures that resources flow to the highest-value uses.
