Cambridge O Level2281

Opportunity cost

Economics 2281 Chapter Notes

What this chapter covers

Opportunity cost - Opportunity costOpportunity cost - The influence of opportunity cost on decision-making
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In this chapter

  1. 1The Core Concept of Opportunity Cost
  2. 2Opportunity Cost for Individuals and Households
  3. 3Opportunity Cost for Firms and Governments
  4. 4Visualising Opportunity Cost with the PPC

1. The Core Concept of Opportunity Cost

In economics, we learn that wants are unlimited, but the resources (like time, money, and materials) to satisfy them are limited. This is called scarcity. Because of scarcity, we are forced to make choices. Every time you make a choice, you have to give something up. Opportunity cost is the value of the next best alternative that you chose not to take. It's not just about money; it's the real cost of any decision. For example, if you have £10 and you choose to buy a book, the opportunity cost is the pizza you could have bought instead. It's the 'what if' or the 'next best thing' you sacrificed.

Key term

Opportunity Cost: The benefit lost from the next best alternative foregone when making a choice.

Examiner insight

Examiners reward students who clearly state that opportunity cost is about the 'next best' alternative, not just any random alternative that was given up.

Common pitfall

Confusing opportunity cost with the monetary price of the chosen item. The opportunity cost is the value of the foregone alternative, not the money spent.

Worked example 12 marks

A student has £10 and can't decide whether to go to the cinema or go bowling. Both activities cost £10. The student chooses to go to the cinema. What is the opportunity cost of this decision?

  1. 1

    Step 1: Identify the choice made. The student chose to go to the cinema.

  2. 2

    Step 2: Identify the alternative(s) foregone. The student gave up the chance to go bowling.

  3. 3

    Step 3: Determine the 'next best' alternative. In this simple case, bowling is the only other option presented, so it is the next best alternative.

  4. 4

    Step 4: State the opportunity cost. The opportunity cost of going to the cinema is the enjoyment and experience the student would have gained from going bowling.

Worked example 23 marks

A social club sold raffle tickets for $10 each. The prize was $250. A student bought one ticket but did not win. What is the opportunity cost to the student of buying the ticket?

  1. 1

    Step 1: Identify the cost of the decision. The student spent $10 on a ticket.

  2. 2

    Step 2: Identify what was given up to make this purchase. The student gave up the ability to spend that $10 on something else.

  3. 3

    Step 3: The opportunity cost is the value of the next best thing that could have been purchased with the $10. This could be a meal, a book, or two cinema tickets, for example.

  4. 4

    Step 4: State the opportunity cost. The opportunity cost is not the $10 itself, but what the student could have bought with that $10.

Recap

  • Scarcity means resources are limited but wants are unlimited.
  • Scarcity forces us to make choices.
  • Every choice involves a cost.
  • Opportunity cost is the value of the next best alternative given up.
  • This 'cost' is the benefit you would have received from the alternative choice.

Quick check

  1. What two fundamental economic concepts lead to the existence of opportunity cost?2 marks

2. Opportunity Cost for Individuals and Households

Opportunity cost is a part of daily life. For individuals, it affects decisions about time, money, and careers. For example, the opportunity cost of taking a two-hour nap is the two hours of revision you could have done. The opportunity cost of buying an expensive car is the round-the-world holiday you could have taken with the same money. For a household, deciding to save money in a bank account has an opportunity cost: the goods and services (like a new sofa or a family outing) they could have enjoyed immediately. Career choices also involve significant opportunity costs. The decision to go to university for three years means giving up three years of potential earnings from a full-time job.

Key term

Trade-off: A situation where having more of one thing requires giving up some amount of another thing.

Fun fact

The phrase 'There ain't no such thing as a free lunch' (TANSTAAFL) is a popular way to express the concept of opportunity cost. Even if something is free to you, resources were used that could have been used for something else, so there is always an opportunity cost to society.

Worked example 12 marks

An individual is choosing between two jobs. Job A pays £30,000 per year but involves long hours. Job B pays £25,000 per year but has a better work-life balance. The individual chooses Job B. What is the opportunity cost of this decision?

  1. 1

    Step 1: Identify the choice made. The individual chose Job B.

  2. 2

    Step 2: Identify the next best alternative foregone. The next best alternative was Job A.

  3. 3

    Step 3: State the opportunity cost. The opportunity cost of choosing Job B is the extra £5,000 in annual salary that would have been earned from Job A.

Worked example 23 marks

A family saves £2,000 for a year to afford a holiday. Explain the opportunity cost of this decision.

  1. 1

    Step 1: The decision is to save £2,000 rather than spend it immediately.

  2. 2

    Step 2: The opportunity cost is the benefit the family gives up by not spending the money now.

  3. 3

    Step 3: This could include immediate satisfaction from buying new clothes, upgrading their TV, or making home improvements.

  4. 4

    Step 4: Therefore, the opportunity cost is the immediate consumption of goods and services that was foregone for a full year.

Recap

  • Individuals face opportunity costs in time management, spending, and career choices.
  • The opportunity cost of education includes foregone wages.
  • Households face opportunity costs when deciding between saving and spending.
  • Everyday decisions have an economic cost, even if no money is spent.

Quick check

  1. What is the primary opportunity cost of choosing to pursue a university degree instead of entering the workforce immediately after school?1 mark

3. Opportunity Cost for Firms and Governments

Firms and governments also face opportunity costs due to scarce resources. A business with a fixed amount of capital must choose which projects to invest in. If a car company invests in developing a new electric car, the opportunity cost might be the new line of petrol cars it could have developed instead. A government has a limited budget raised from taxes. If it decides to spend £50 billion on a new high-speed railway, the opportunity cost is what that £50 billion could have been spent on otherwise. This could be building 1,000 new schools, hiring 100,000 more nurses for 10 years, or simply not collecting the tax in the first place and allowing taxpayers to spend their own money.

Key term

Resource Allocation: The process of assigning and managing assets and resources to support an organization's or economy's strategic goals.

Examiner insight

When discussing government spending, top answers provide a specific and realistic alternative use of the funds, such as 'building 10 new schools' rather than just 'spending on education'.

Worked example 14 marks

A government has increased its spending on the police and armed forces. Explain why this policy has an opportunity cost. [4]

  1. 1

    Step 1: Define opportunity cost. Opportunity cost is the benefit lost from the next best alternative foregone. (1 mark)

  2. 2

    Step 2: Relate this to the government's budget. The government has a finite budget from tax revenue, meaning spending more in one area requires a trade-off. (1 mark)

  3. 3

    Step 3: Identify the opportunity cost. By spending more on police and armed forces, the government has fewer resources to spend on other public services. (1 mark)

  4. 4

    Step 4: Provide a specific example. The opportunity cost could be the new hospitals that cannot be built, the improvements to the education system that are foregone, or the funds that could have been used to lower taxes. (1 mark)

Worked example 22 marks

A factory can use its machines and workers to produce either 300 glass bottles or 400 glass jars per day. What is the opportunity cost of producing 300 glass bottles?

  1. 1

    Step 1: Identify the choice. The factory chooses to produce 300 glass bottles.

  2. 2

    Step 2: Identify the next best alternative production option. The factory could have produced 400 glass jars instead.

  3. 3

    Step 3: State the opportunity cost. The opportunity cost of producing 300 glass bottles is the 400 glass jars that are not produced.

Recap

  • Firms face opportunity costs when deciding what goods to produce or which projects to fund.
  • Governments face opportunity costs when allocating their annual budgets.
  • The opportunity cost of government spending can be other public services or lower taxes.
  • Decisions on resource allocation are central to business and government strategy.

Quick check

  1. State one possible opportunity cost of a government's decision to build a new motorway.1 mark

4. Visualising Opportunity Cost with the PPC

The Production Possibility Curve (or PPC) is a graph that shows the different combinations of two goods an economy or firm can produce using all available resources efficiently. The curve demonstrates scarcity (as you can't produce unlimited amounts), choice (choosing a point on the curve), and opportunity cost. To produce more of one good, you must move along the curve, which means producing less of the other. The amount of the other good you give up is the opportunity cost. The slope of the PPC at any point represents the opportunity cost of producing one more unit of the good on the horizontal axis.

Opportunity Cost of Good X = (Loss in Good Y) / (Gain in Good X)

Key term

Production Possibility Curve (PPC): A curve showing the maximum combinations of two goods that can be produced with a given set of resources and technology, assuming full and efficient use.

Examiner insight

Students who can accurately calculate opportunity cost from a PPC table or diagram, and explain what a movement along the curve signifies, consistently score high marks.

Common pitfall

Incorrectly calculating the opportunity cost from a PPC diagram by mixing up the 'gain' and 'loss' values or misreading the axes.

Worked example 13 marks

A firm can produce either 500 of good X and 300 of good Y, or 600 of good X and 250 of good Y. What is the opportunity cost of producing an extra 100 of good X?

  1. 1

    Step 1: Identify the change in production of good X. The firm increases production from 500 to 600, which is a gain of 100 units of X.

  2. 2

    Step 2: Identify the corresponding change in production of good Y. Production of Y falls from 300 to 250, which is a loss of 50 units of Y.

  3. 3

    Step 3: State the opportunity cost. To produce an extra 100 units of good X, the firm must give up 50 units of good Y. Therefore, the opportunity cost is 50 Y.

Worked example 22 marks

An economy produces wheat and barley. If it increases its output of wheat from 300 tonnes to 400 tonnes, its output of barley falls from 800 tonnes to 680 tonnes. What is the opportunity cost of increasing the output of wheat by 100 tonnes?

  1. 1

    Step 1: Calculate the increase in wheat production. Change in wheat = 400 - 300 = +100 tonnes.

  2. 2

    Step 2: Calculate the decrease in barley production. Change in barley = 800 - 680 = -120 tonnes.

  3. 3

    Step 3: The opportunity cost of the extra 100 tonnes of wheat is the 120 tonnes of barley that can no longer be produced.

  4. 4

    Step 4: State the final answer. The opportunity cost is 120 tonnes of barley.

Recap

  • The PPC shows the maximum possible output combinations of two goods.
  • Points on the PPC are efficient; points inside are inefficient; points outside are unattainable.
  • Moving along the PPC demonstrates a trade-off and incurs an opportunity cost.
  • The slope of the PPC measures the opportunity cost.
  • A straight-line PPC shows constant opportunity cost, while a bowed-out curve shows increasing opportunity cost.

Quick check

  1. What does a point inside the PPC represent?1 mark
  2. What does a point outside the PPC represent?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the relationship between the concepts of scarcity, choice, and opportunity cost.4 marks
  2. A student has 3 hours of free time. They can either work at a part-time job earning £10 per hour, revise for an upcoming Economics test, or watch a movie. They choose to revise. Explain the opportunity cost of their decision.3 marks
  3. A firm has the resources to produce either 1,000 smartphones or 500 laptops per month. What is the opportunity cost of producing one laptop?2 marks
  4. A government decides to spend $2 billion on subsidies for renewable energy. Describe two different opportunity costs of this decision.4 marks
  5. The table shows the production possibilities for an economy that produces only cars and computers. Calculate the opportunity cost of increasing car production from 20 to 30 units. Show your working. | Cars (thousands) | 0 | 10 | 20 | 30 | 40 | | Computers (thousands) | 100 | 95 | 85 | 70 | 50 |3 marks
  6. Using a Production Possibility Curve (PPC) diagram, illustrate and explain a point of inefficient production and a point that is currently unattainable.5 marks
  7. A self-employed plumber decides to take a two-week unpaid holiday. Explain the opportunity cost of this decision.4 marks
  8. 'Opportunity cost is only a problem for the poor. The rich can buy whatever they want, so they don't have opportunity costs.' Discuss the validity of this statement.6 marks
  9. Explain how the concept of opportunity cost might be relevant to an individual's choice of occupation.6 marks
  10. An economy is at a point on its PPC, producing a mix of consumer goods and capital goods. If it decides to increase the production of capital goods, what is the immediate opportunity cost? What might be the long-term benefit of this decision?6 marks

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