Why is the idea of opportunity cost so important in economic thought?

The concept of opportunity cost was devised by Friedrich Von Wieser in his book ‘Theorie der gesellschaftlichen Wirtschaft’. The concept, opportunity cost, is simply described as “the value of the next best alternative forgone”. This is based upon the idea that for every economic decision made, another opportunity is missed- this is the cost paid for any economic decision. The concept of opportunity cost is illustrated by the saying, “there is no such thing as a free lunch”, because even if the lunch was completely paid for, there remains the cost of what else could have been done within that time. However, although the concept is described as ‘simply’, it should be remembered that it is a concept which is vital to our understanding of the economy.

The concept of opportunity cost is vital to economics as all factors of production are finite (a limited number), meaning that it is not possible to purchase every factor leading to the cost of one factor when another is purchased. This concept can be applied to all decision making within the economy. This raises one of the greatest economic problems – how do we allocate these finite resources among infinite wants? Due to finite amounts of every factor within the economy, every actor (especially entrepreneurs) must decide what costs they are willing to accept in order to gain their own personal goals. When all opportunity costs are managed correctly, the market can then prosper. However, the major effect of the concept of an opportunity cost arises when the wrong economic decision is made and the cost of the decision heavily outweighs the benefits. This is where market failure occurs.

If the opportunity cost of a decision is mismanaged, it often leads to a misallocation of resources because the resources they missed would have been worth far more than what was purchased, and eventually this limits production due to not having the right factors. This may then have knock on effects on other groups, especially if they were relying on the previous group within their production. This is where the market may become seriously harmed. A large scale damage of miscalculating an opportunity cost can be seen in the Japanese economy during the 1990s. A major factor in their economic collapse was when most resources were spent, not on an effective infrastructure to sustain growth, but instead on achieving immediate growth. In the long run, this contributed to one of the most famous economic collapses, due the cost of spending on an immediate future over a sustained future, which was not fully appreciated.

Although, by many, an opportunity cost is dubbed as a ‘simple’ definition, it can be seen as an extremely complex issue that plays a major role in every aspect of every economy. It is one of the few practical concepts that deal with the problem of finite resources; it can be demonstrated that if the costs are not understood, there can be detrimental consequences.

Contributed by Robbie Lunniss

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