According to the opportunity cost theory, if a given amount of various factors of production (that is, land, labour, capital and enterprise) can produce either one unit of Commodity A or, one unit of Commodity B, then the opportunity cost of producing one unit of Commodity A is one unit of Commodity B which is foregone or sacrificed.
In other words, the cost of producing a commodity is the quantity of another commodity that must be given up or sacrificed, given a particular combination of various resources or factors of production.
Opportunity cost includes both explicit costs and implicit costs.
Cost and Profit is computed by accountant as well as an economist. However, there is a difference in the manner in which each of them calculates a cost. For this, we first need to understand Accounting Profit and Economic Profit concepts:
We all know that profit is total revenue that remains after subtracting total costs. However, profit will differ if cost is calculated differently.
To illustrate further, let us take a hypothetical example where Chef Steve has a well-known restaurant that serves Italian food. Apart from this, Steve is also a qualified gym trainer and can easily earn $10/hour if he starts giving training classes to people. Let’s say, in a month Steve’s restaurant did very well and he earned $5,000 by putting in 250 hours in the month. His costs for making food, salaries etc. amount to $1,500 for the month.
Now, in this case:
In this example, when an accountant will calculate Accounting Profit, only explicit costs will be considered such that Accounting Profit will be $3,500. However, when an Economist will calculate Economic Profit, apart from considering explicit costs, economist will also consider implicit costs. Hence, the Economic profit will be $1,000. As a result, Economic Profit will always be lesser than Accounting Profit.
The Opportunity Costs theory can also be presented graphically through a curve popularly known as Production Possibility Frontier. The curve represents choice between two commodities which are presented on either axes (x axis and y axis). Given fixed quantity of various factors of production, the individual or economy needs to choose between units of the two commodities that can be produced.
For example, let’s say an economy needs to produce shirts and bread. With the fixed resources economy has, it can produce these two commodities in following combinations:
Graphically, this can be presented as follows:
The red curve in above graph indicates maximum capacity of an economy, given the fixed factors of production. Hence, there are various combinations of bread and shirts depicted on this red curve. For example, 60 bread and 10 shirts or 30 bread and 40 shirts and so on and so forth. The economy will try and produce a combination that caters to needs of its people in an optimum manner.
The shape of PPF curve can be categorized as follows:
Francis Edgeworth developed this concept but Vilfredo Pareto was the author of the indifference curves as we know them today.
By definition, indifference curve is a curve representing various combinations of commodities which provide same level of satisfaction for the consumer. In other words, a consumer is indifferent between these combinations of commodities as he derives same utility and satisfaction from any such combination. Below is an example of indifference curve map with three different curves (I1, I2 and I3):
Hence, in above figure a consumer on I1 curve is indifferent at any point on the curve, However, as the capacity of economy increases, more goods can be produced leading to higher level of satisfaction and utility. The curve itself will shift to I2. In this case, a consumer will prefer to be on I2 instead of I1 as it provides higher satisfaction. But along I2, again the consumer is indifferent. Similarly, I3 is preferred to both I1 and I2.