ASSUMPTIONS OF OPPORTUNITY COSTS

The concept of opportunity costs is based on the following assumptions:-

1) Factors of production are freely mobile.
2) Perfect competition prevails in the market.
3) All the units of factors of production are homogeneous.
4) There prevails full employment of resources.
5) Factors of production are not specific as they can be put to alternative uses.
# APPLICATIONS OF OPPORTUNITY COST
1. Determining factor prices:-The factors for production need a price equal
to or greater than what they command for alternative uses. If the factor price
is less than the factor’s opportunity cost, then the said factor moves to the
better-paying alternative.
2. Determining economic rent:-Many modern economists use this concept
for determining economic rent. As per them, economic rent = The factor’s
actual earning – Its opportunity cost or transfer earning
3. Consumption pattern decisions:-According to this concept, if with a given
amount of money a consumer chooses to have more of one thing, then he
needs to have less of the other.
Further, he cannot increase the consumption of all the goods at the same time.
Therefore, he decides his consumption pattern using the concept of
opportunity cost.
4. Product plan decisions:- Let’s say that a producer has fixed resources and
technology. If he wants to produce a greater amount of one commodity, then
he must sacrifice the quantity of another commodity.
Therefore, he uses this concept to make decisions about his production plan.
5. Decisions about national priorities:- Every country has certain resources
at its command and needs to plan the production of a wide range of
commodities. This decision depends on the national priorities which are
based on opportunity costs.
For example, if a country is at war, then it will use its resources to produce
more war-related goods as compared to civilian goods.
# TYPES OF OPPORTUNITY COST IN PRODUCTION
1. Explicit Cost:-Explicit costs are the cost which includes the monetary
payment from the producers.
For example, if the company is paying $1000 per month in food by providing
free lunch and breakfast, then its explicit OC is $1000. The expenditure on
food could have been used somewhere else.
2. Implicit Cost:-Implicit cost aka national cost can be defined as the OC
which a company used in order to produce something.
For example, a company purchased small electronic devices to produce
mobile phones, laptops, etc. This cost is used to produce something, the
electronic devices are not sold or rented.
3. Marginal Cost:-Marginal opportunity cost is a cost required to produce
something extra.
For example, currently a company is producing 1000 burgers per day, but
due to heavy demand, they are running out of the burgers. So, the company
decided to hire more people and cook more burgers.
Now marginal opportunity cost will include – payment of new employees, cost
required for ingredients required to cook more burgers, profit company was
missing before and many other extra costs required for producing additional
burgers.
# CONSIDERABLE FACTORS OF OPPORTUNITY COST
While investing money, time and effort, the person has to look for the option
of giving the highest possible return on investment. Thus, giving up the value
he would have yielded from the second-best alternative.
1. The monetary value invested in any opportunity must provide an
adequate return to the investor. Therefore, money is an essential factor
involved in opportunity cost.
2. Time is a valuable asset, and once invested, cannot be reversed. The
benefit which a particular opportunity provides over the period must be the
highest as compared to the other alternatives.

3. The energy invested in the chosen alternative is equally essential and

requires a lot of skills and evaluation.
# SIGNIFICANCE OF OPPORTUNITY COST
Opportunity cost is an inevitable part of any business activity since it triggers
the process of decision making.
The primary reasons for which any business needs to determine the
opportunity cost are as follows:
1) Base for Decision Making: Opportunity cost provides support for making
an appropriate choice while selecting one out of many available alternatives.
2) Price Determination: Based on the expenses incurred in the procurement
of any goods or services along with the cost which may have been committed
to acquiring alternative options, the price of the products or services is
determined.
3) Efficient Resource Allocation: It helps in investing the resources in the
right opportunity by analyzing the opportunity cost of all the alternatives.
4) Remuneration Decisions: In organizations, it played a crucial role in
determining the expected value an employee would create for the
organization. It is acquired after his/her comparison to the other
alternatives available, and thus, personnel remuneration is considered
accordingly.
# CRITICISM OR LIMITATIONS OF OPPORTUNITY COSTS
The following are leveled against the concept of opportunity cost:-
1. Opportunity costs in the case of factors of production can’t be calculated
easily.
2. This concept is not useful for calculating the risks and pains undergone by
the entrepreneur in production process.
3. This concept is applicable only when perfect competition prevails. But in
actual practice perfect competition is a myth.
4. Factors of production are not freely mobile between different alternative
employments. So opportunity cost of each factor can’t be known.
5. This concept is not applicable in the case of specific factors.
6. This concept is based on the homogeneity of factors. But all the units of
factors of production are not homogeneous in reality.
7. This concept assumes that resources are constant and do not change. So it is
a static concept.
8. Factors of production influenced by elements like inertia may not move
from one industry to the other.
9. This concept fails to take into consideration social costs like ill-health,
environmental pollution etc. arising due to the expansion of industries ost and
incremental revenue.
INCREMENTAL CONCEPT
The incremental concept is probably the most important concept in
economics and is certainly the most frequently used in Managerial Economics.
Incremental concept is closely related to the marginal cost and marginal
revenues of economic theory.
The two major concepts in this analysis are incremental
Incremental cost denotes change in total cost, whereas incremental revenue
means change in total revenue resulting from a decision of the firm.
Incremental cost may be defined as the change in total cost as a result of
change in the level of output, investment, etc.
Incremental Revenue is change in total revenue resulting from change in
level of output , price etc.
Incremental cost is the total cost incurred due to an additional unit of product
being produced. Incremental cost is calculated by analyzing the additional
expenses involved in the production process, such as raw materials, for one
additional unit of production. Understanding incremental costs can help
companies boost production efficiency and profitability.
The incremental principle may be stated as follows:-
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
Example:- Suppose that you have a business that manufactures Smartphone's
and expect to sell 20,000 units. It costs you $100 to manufacture each
Smartphone’s, and your selling price per Smartphone’s is $300.
Incremental cost
You calculate your incremental cost by multiplying the number of
Smartphone’s units with the manufacturing cost per Smartphone’s unit.
So, in this case, you will have:
20,000 x 100 = 2,000,000
So, incremental cost is $2,000,000.
Incremental revenue
You calculate your incremental revenue by multiplying the number of
Smartphone's units with the selling price per smart phones unit.
So, you will have:
20,000 x 300 = 6,000,000
So, incremental revenue is $6,000,000.
When you compare the two, it is clear that the incremental revenue is higher
than the incremental cost. By subtracting the incremental cost from the
incremental revenue, you arrive at a profit of $4,000,000.
Illustration:- Some businessmen hold the view that to make an overall profit,
they must make a profit on every job. The result is that they refuse orders that
do not cover full costs plus a provision of profit. This will lead to rejection of
an order which prevents short run profit. A simple problem will illustrate this
point. Suppose a new order is estimated to bring in an additional revenue of
Rs. 10,000. The costs are estimated as under:
Labour Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of Rs. 2,000.
However, suppose there is idle capacity which can be utilised to execute this
order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way
of labour cost because some of the idle workers already on the pay roll will be
deployed without added pay and no extra selling and administrative costs,
then the actual incremental cost is as follows:
Labour Rs. 2,000
Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of
incremental reasoning. Incremental reasoning does not mean that the firm
should accept all orders at prices which cover merely their incremental costs.
# LIMITATIONS OF INCREMENTAL COSTS.
The concept is mainly used by the progressive concerns. Even though it is a
widely followed concept, it has certain limitations:
(a) The concept cannot be generalised because observed behaviour of the firm
is always variable.
(b) The concept can be applied only when there is excess capacity in the
concern.
(c) The concept is applicable only during the short period.
CONCEPTS OF SCARCITY
Scarcity means “of limited availability”.
Example:-During Famine period, food is ‘scarce’ i.e. Scarcity of food.
Scarcity is a fundamental economic problem of having humans who have
unlimited wants & needs in world of limited resources
Scarcity refers to the limited availability of a commodity, which may be in
demand in the market.
The concept of scarcity was first given by Lionel Robbins. This explains an
individual’s capacity to buy all or some of the commodities as per the available
resources with that individual.
Robbins is famous for his definition of economics: "Economics is the science
which studies human behaviour as a relationship between ends and scarce
means which have alternative uses."
Scarcity is the fundamental economic problem of having seemingly
unlimited human wants in a world of limited resources. It states that society
has insufficient productive resources to fulfill all human wants and needs.
Scarcity refers to the condition of insufficiency where the human beings are
incapable to fulfill their wants in sufficient manner. In other words, it is a
situation of fewer resources in comparison to unlimited human wants. Human
wants are unlimited. We may satisfy some of our wants but soon new wants
arise. It is impossible to produce goods and services so as to satisfy all wants
of people. Thus scarcity explains this relationship between limited resources
and unlimited wants and the problem there in.
Economic problems arise due to the scare goods. These scare goods have
many alternative uses.
For example:- a land can be used to construct a factory building or to make a
beautiful park or to raise agricultural crops. So, it is very essential to think
how limited resources can be used alternatively to satisfy some wants of
people to get maximum satisfaction as possible. The problem of scarcity is
present not only in developing countries but also in highly developed
countries such as Japan, Canada, etc. Thus, scarcity is the heart of all economic
problems.
# When will a resource be consider as ‘SCARCE’?
A resource is considered scarce when its availability is not enough to meet its
demand.
For example:- When supply of onion in market is not enough to meet the
demand, that condition can be referred as Scarcity of Onions.
In arid areas, like Rajasthan, there is lack of water i.e. supply of water≠ its
demand. This condition is called scarcity of water. Moreover, in institutions,
when supply of internal marks is not enough to meet the demand of students,
this condition is called scarcity of Internals.
# FACTORS RESPONSIBLE FOR SCARCITY OF RESOURCES
1) Limited supply of resources (natural Scarcity)
for example,
scarcity of water in arid areas like deserts,
scarcity of food in famine prone areas.
2) Limited capabilities of technology or human skill (for example, those
needed for enhanced production.)
3) Sometimes the insufficiencies are a result of poor planning & execution
(Artificial scarcity).
Example In arid areas, proper planning is required for proper supply of
water.
4) But the most important factor is imbalance b/w ‘Wants’ &’Have’.
According to Emerson:- “Want is a growing giant whom the coat of Have is
never large enough to cover.”
Every person needs more resources than he have. millionaire wants more
money so that he can be counted as Billionaire
# Is it Possible to Have no Scarcity?
1. If proper planning & techniques are used for utilization and supply of
insufficient resource, then condition of its to be scarce ‘minimizes’.
2. If ‘needs’=‘have’
3. If through spiritual practice and detachment you had very few desires –
Example a monk or sannyasin then you would not see scarcity – as you would
be content with just your daily bread.
4. If you lived on an island with abundant resources and a small population,
then the scarcity of resources would be less obvious.
5. But, in present society, most people desire more than just a loin cloth and a
begging bowl.
# How to manage the condition of Scarcity?
To manage the condition of Scarcity of resources, proper planning for supply
& utilization of insufficient goods is required. This results in rise of three
major economic issues:-
What to produce?
How to Produce?
For whom to produce?
1) What to Produce?
When making decisions about what to produce or what to consume, there is
inevitably an opportunity cost.
For Example:- GDP of country can be used for many purposes. However,
option having highest opportunity cost will be favored.
2) How to produce?
Use of best possible technique & planning for production of a particular
resource will result in better & huge production, hence minimizing the chance
For Example:- Before, the introduction of Green Revolution in India, there
was Scarcity of Food grains. But with the introduction of High Yielding
varieties of seeds & better technique for production, production of Food
grains almost doubled.
3) For whom to produce?
This means how the produced goods and services are to be distributed among
different income groups of people that is who should get how much. This is
the problem of sharing of the national product.
# Impact of Scarcity on Market?
1) If something is scarce - it will have a market value.
2) It will result in inflation.
3) If the supply of a good or service is low, the market price will rise,
providing there is sufficient demand from consumers. Whereas when there is
excess supply in a market, we expect to see prices falling.
For example:- If we talk about services, IITians vs. Engineer from UPTU
colleges.