Law of Increasing Opportunity Cost - Research Paper Example

There is no such thing as free lunch (Opportunity Cost) Introduction "There is no such thing as'a free lunch"'(TINSTAAFL) expresses the idea'that even if something seems like it is free, there is always a cost, no matter how indirect or hidden. In finance, it refers to the opportunity cost paid to make a decision. The decision to consume one product usually comes with the trade-off of giving up the consumption of something else (Investopedia, 2009). The phrase 'TINSTAAFL' believed to be originated from some shops in United States which offered free lunch to their customers who purchase a drink. In other words, these salon owners offered the free lunch and at the same time they accommodated the cost of it in the cost of the drink. The customers may thin k that they are getting a free meal at the cost of a drink and hence more people would be attracted towards the shop. This paper briefly explains the phrase 'TINSTAAFL' in terms of opportunity cost. 'TINSTAAFL' in terms of opportunity cost Opportunity cost is the cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement" (Opportunity cost, n. d). Every problem has more than one solution as economics says. While solving problems we normally opt for the best possible solution. But it is not necessary that our decisions would be always the best because of our inability to analyze or evaluate problems properly. If another better option was available, the opportunity cost is the benefits we could have received by taking that option. In the current world, there are lots of investment opportunities. Some of them may be risky while the others might be risk free. For example, consider a person invest his entire extra money in a savings bank account which provides him an annual interest of below 3%. On the other hand, if that person invests his money in fixed deposits, he can earn more than 8% interest. Here the person losing 5% (8 - 3 = 5) and his opportunity costs are 5% In the initial example of the salon owners who offer free lunch, they are not losing any money since they are accommodating the charges of the meals in the charge of the drink. But at the same time they were able to attract more customers because of this business strategy. In other worlds, the salon owners were able to make more profit by selecting an alternate option for selling their drinks. It should be remembered that if the salon owners do not offer any free lunch and function like other shop owners, their sales might be the same as that of the others. But by selecting an alternate option without sacrificing anything, they were able to increase their profit. "Any decision that involves a choice between two or more options has an opportunity cost" (Joanne, 2008)' Characteristics of Opportunity cost Thus the opportunity cost is not restricted to financial costs alone. The real cost of output forgone, lost time, or any other benefit that provides utility should also be considered as opportunity costs. Consider a person with $ 100 in his hand. He can purchase some shirts or some books or even he can invest it in shares or fixed deposits. If he purchases shirts or books for the money he has, the value of the goods may decrease as time passes and he loses his money as opportunity cost. At the same time if he invests the money in term deposits, he may get more money as time passes. In other words the same money yields negative opportunity cost in the first instance whereas it yields positive opportunity cost in the second instance. Opportunity cost is a key concept in economics because of its worth and value in taking decisions. It is capable of describing the economic terms like scarcity and choice and moreover it can establish the relationship between the two scarcities and choices. For example, scarcity of a commodity creates demand in a market. Thus the prices of the scarce good may go high. People may not have many choices left in such circumstances. For example, the current economic crisis has resulted in many people losing their jobs. Their financial stability has been destroyed and they were left with no choice, but to reduce their expenses as much as possible. Those who used own cars for travelling purposes, started to use line buses more frequently in order to cut down their expenses. Thus the scarcity of money has increased the need of line buses and the private people exploited this situation by increasing the bus fare in some countries. Thus the private bus owners utilized these opportunity very well to increase their profit. In other words, the global financial crisis has affected private bus owners and the public differently. Opportunity cost can ensure that scarce resources are used efficiently. As stated in the above example, the scarcity of money forced the public to take more care while spending their money. The American public who was supposed to be one of the worst affected population because of financial crisis, has already started cut down their expenses and started to save their extra money for future. Thus opportunity cost can force people to take sound decisions at times. The Law of increasing opportunity cost The law of increasing opportunity cost states that the value of foregone production, increases as the quantity of a good produced increases. The law of increasing opportunity cost is fundamental to the production and supply of goods. In general, as the economy increases the quantity supplied of a good, the opportunity cost increases (LAW OF INCREASING OPPORTUNITY COST, 2009). When an economy wants to produce more of one product it must give up successively larger amounts of the other products it makes (Joanne, 2008). The available resources may not be the same everywhere. Moreover same resource may be useful to make different products. For example, fertile land is suitable for different type of agricultural crops. If the farmers concentrate only in producing or cultivating wheat, it would affect the production of barley. In other worlds, the opportunity cost of producing the barley may become more because of the lack of fertile land available for its cultivation. This lack of fertile land is caused by the over usage of the land for producing wheat crops. Thus increase in the production of wheat may decrease the production of barley and thereby increases its opportunity cost. "Because resources are not equally productive in all possible uses, shifting resources from one use to another brings the law of increasing opportunity costs into play.' The production of additional units of one product requires the sacrifice of increasing amounts of the other products so a society should first employ those resources that are relatively efficient at producing that good, only afterward turning to those that are less efficient" (Joanne, 2008). The law of increasing opportunity cost can be easily understood using the graph provided below. Here the production possibilities schedule for crab puffs and storage sheds are displayed. The opportunity cost of producing the first storage shed is 5 dozen crab puffs. At the bottom of this schedule, the opportunity cost of producing the tenth storage shed is 200 dozen crab puffs. The slope of the production possibilities curve is the opportunity cost of the good measured on the horizontal axis, which in this example is storage sheds. Opportunity cost values for segments between each pair of points is presented on this production possibilities curve. The opportunity cost of producing the first shed, and the slope of the curve moving from point A to point B, is 5 dozen crab puffs (or -5). Moving along the production possibilities curve, the slope becomes steeper (that is, the absolute value of the slope increases), reaching a value of -200 (an absolute value of 200) between points J and K. This reflects the law of increasing opportunity cost and results in the convex shape for the production possibilities curve (LAW OF INCREASING OPPORTUNITY COST, 2009) Application of Opportunity cost The economic term opportunity cost has wide range of applications in our daily life. It can be applied in determining the; consumer choice, production possibilities, cost of capital, time management, career choices, comparative advantage etc. (NetMBA, 2007) Consumer choices are changing always because of the huge development in science and technology. Economic principles were also undergoing drastic changes at present in order to accommodate the changing needs of the consumers. For example, globalization like a revolutionary policy was unimaginable around 20 to 30 years before. But the world has realized the importance and scope for collective growth at present. Free market is a modern economic concept which was unimaginable earlier. Consumers want better product at affordable price. They don't bother about whether it is domestically made or not. For example, Chinese products are dominating in the world market because of cheaper prices. The consumers look for such products purely because of the cheaper prices. It is not possible to establish a tire manufacturing unit everywhere. It can be established wherever the major raw material rubber is easily available. Otherwise the cost of producing tire would go high because of the increased expenses for transporting goods. Thus even the production possibilities of a good can be determined by the opportunity cost associate with it. "The cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. It is alternatively referred to as the opportunity cost of capital or the required rate of return. It is calculated based on the expected average rate of return of investors in a firm" (Money Instructor, 2005). Cost of capital would be determined on the basis of the opportunity cost. For example, nobody want to invest heavily in real estate or share business at present because of the pathetic conditions and risk involved in these segments because of the current financial crisis. Reports showed that many real estate firms were on the verge of closing down because of fewer sales at present. No investor would go for investing heavily in construction sector at present because of less demand and increased risk involved in it. In other words, opportunity cost helped the real estate business people and the investors in effective time and capital management. Comparative advantage is the ability of one business entity to engage in production at a lower opportunity cost than another entity. Comparative advantage, rather than absolute advantage, is useful in determining what should be produced and what should be acquired through trade (Comparative advantage, n. d). Conclusions Opportunity cost is associated with any decision that involves a choice between two or more options. Opportunity cost is not limited to financial terms alone. Any benefit that provides utility should be considered as opportunity costs. Sometimes the opportunity cost might not be visible, but still it lies in the grass root level in invisible shape as we seen in the case of free lunch provided by the salon owners for every purchase of a drink. Opportunity cost can be negative and positive as well depending on the circumstances and the decisions taken. Opportunity cost can ensure that scarce resources are used efficiently by the people. As per the law of increasing opportunity cost, the value of production increases as the quantity of a good produced increases. Opportunity cost analysis help us in predicting consumer choice, production possibilities, cost of capital, time management, career choices, comparative advantage etc. References 1. Comparative advantage, (n. d), Retrieved on 19 November 2009 from http://www.investorwords.com/5465/comparative_advantage.html 2. Investopedia, (2009)There Ain't No Such Thing As A Free Lunch - TANSTAAFL, Retrieved on 19 November 2009 from http://www.investopedia.com/terms/t/tanstaafl.asp 3. Joanne (2008), Macro economics- What is the economic rationale for the law of increasing costs' Retrieved on 19 November 2009 from http://www.college-cram.com/study/economics/weblog/macro-economics-what-is-the-economic-rationale-for-the-law-of-increasing-costs-1 4. LAW OF INCREASING OPPORTUNITY COST, (2009), Retrieved on 19 November 2009 from http://www.amosweb.com/cgi-bin/awb_nav.pl's=wpd&c=dsp&k=law+of+increasing+opportunity+cost 5. Money Instructor, (2005), Cost of Capital, Retrieved on 19 November 2009 from http://www.moneyinstructor.com/art/costcapital.asp 6. NetMBA, (2007), Opportunity cost, Retrieved on 19 November 2009 from http://www.netmba.com/econ/micro/cost/opportunity/ 7. Opportunity cost,( n. d), Retrieved on 19 November 2009 from http://www.investorwords.com/3470/opportunity_cost.html Read More