Lecture 3

Opportunity Costs and Trade-Offs

 Opportunity Costs and Trade-Offs

• Opportunity cost is the cost of missing out on the next best alternative.
• In other words, opportunity cost represents the benefits that could have
been gained by taking a different decision.
• All businesses have to make choices - and those choices have implications.

• In business, resources are usually scarce or limited hence we are

confronted with choice to make.
• Decision are made under circumstances of uncertainty and taking one
course of action or decision may affect business ability to take an
alternative action.

• Opportunity cost measures the cost of a choice made in terms of the next
best alternative foregone or sacrificed. 
Examples of Opportunity Cost in the Business &
Economic Environment

• Work-leisure choices
• The opportunity cost of deciding not to work an extra ten hours a week is
the lost wages given up. 
• Government spending priorities
• The opportunity cost of the government spending an extra ZMW10 billion
on investment in National Health Service might be that ZMW10 billion less
is available for spending on education or defense equipment.
• Investing today for consumption tomorrow
• The opportunity cost of an economy investing resources in new capital
goods is the production of consumer goods given up for today
• Use of scarce farming land
• The opportunity cost of using farmland to grow maize for bio-fuel means
that there is less maize available for food production, causing food prices
to rise
 Trade-offs

• Trade-offs
• A trade-off arises where having more of one
thing potentially results in having less of
another.
• The table below lists some examples of how
trade-offs often arise in business - as a result
of resource scarcity.
Some Examples
Difference Between Trade-off and Opportunity Cost
 Making Choices
•Economics is all about making choices, in order to make best possible use of
the scarce resource.
•Whenever we make a choice among various alternatives, we have to forgo
other options.
•In this context, two economic terms are often misconstrued, which are the
trade-off and opportunity cost.
•While a trade-off denotes the option we give up, to obtain what we want.
•On the other hand, the opportunity cost is the cost of the second best
alternative given up to make a choice.
•In other words, it is the cost of the opportunity that is missed and so it
makes a comparison between the project accepted and the rejected one.
 Comparison Chart
BASIS FOR OPPORTUNITY
COMPARISON TRADE-OFF COST
Meaning Trade-off implies Opportunity cost
the exchange of implies the value
one thing to get of choice
another. foregone, to get
something else.
What is it? The choices The value of next
sacrificed. best alternative.
Represents What is given up What could have
to get what is been done, with
wanted? what was given
up?
 Understanding Trade off and Opportunity
Cost
• Definition of Trade-off
• In economics, trade-off means the exchange, in which a person
sacrifices one or more things for getting a particular product, service
or experience.
• It refers to all the courses of action which could be employed, other
than the present one.
• It is a deal, that arises as a compromise, wherein to obtain a certain
aspect we have to lose another aspect.
• In other words, while making a selection, we have to accept less of
something, for obtaining more of something else, the outcome would
be trade-offs. 
 Example
• Suppose a company wants to start a project,
which requires huge investment and other
resources,
• so the trade-off entails the reduction in certain
expenses, in order to invest more in the new
project.
• Hence, tradeoff implies the way of forsaking
one or more desirable alternatives, in return for
obtaining a specified outcome.
 Situational Analysis of Trade Off
• A trade-off is an exchange of one thing for another, or accepting less of
one thing for more of another.
• For example, if you have the choice of seeing your parents, seeing your
friends or staying in tonight, you are facing a trade-off.
• In order to see what your trade-off is, though, you must pick your top
two choices.
• If you decide you will see your friends, but your next choice would have
been to see your parents, then seeing your parents is the trade-off for
seeing friends.
• The trade-off can change depending on the choice you make and what
you view as the next best alternative.
 Calculating a Trade-Off

• There is no specific calculation for a trade-off, so determining the

trade-off in any situation is not always easy.
• When deciding between two or more courses of action, ranking
the alternatives from top to bottom can make you feel more
confident that you are picking the right one.
• If you make a choice but cannot accept what you will have to give
up as part of the trade-off, consider revising your choice.
• Since there is no specific calculation for trade off, cost valuation of
this is not possible, unless through social cost or Proxies (shadow
costs) valuation effect which is highly subjective.
• Shadow prices are simply the estimated prices of goods or services
for which no market price exists.
 Social costs
• Social cost in neoclassical economics is the sum of the private
costs resulting from a transaction and the costs imposed on
the consumers as a consequence of being exposed to the
transaction for which they are not compensated or charged.
•  In other words, it is the sum of personal and external costs.
• Private costs refer to direct costs to the producer for
producing the good or service.
• Social cost includes these private costs and the additional
costs (or external costs) associated with the production of the
good for which are not accounted for by the free market.
 Mathematical Definition
•Mathematically, social marginal cost is the sum of private marginal cost and the external
costs i.e. SC= MC+ EC
• For example, when selling a glass of lemonade at a lemonade stand, the private costs
involved in this transaction are the costs of the lemons and the sugar and the water that are
ingredients to the lemonade- explicit costs, the opportunity cost of the labor to combine
them into lemonade, as well as any transaction costs, such as walking to the stand.
•An example of marginal damages associated with social costs of driving includes wear and
tear, congestion, and the decreased quality of life due to drunks driving or impatience, and
many people displaced from their homes and localities due to construction work,
environmental degradation.
• In their simplest words it is the private cost + external cost.
•The alternative to the above neoclassical definition is provided by the heterodox economics
 theory of social costs by K. William Kapp.
•Social costs are here defined as the socialized portion of the total costs of production, i.e.,
the costs which businesses shift to society in their attempts to increase their profits.
 Opportunity Cost
• Definition of Opportunity Cost
• Opportunity cost or alternative cost, as the name suggest, is the cost of
opportunity lost,
• i.e. an opportunity to generate revenue is lost, because of the scarcity of
resources such as labour, material, capital, plant and machinery, land and so on.
• It is the actual return of the forsaken alternative, which cannot be obtained, due
to the scarcity of resources.
• As we know that resources are available to us, in a limited quantity, but these
resources have diverse uses, with varied returns.
• So, the resources are employed to the most productive use, by sacrificing the
next best use of the resources.
• Hence, the opportunity cost is the amount of return that is expected to be
generated when the resources are put to the second best alternative.
 Example
• Suppose after pursuing MBA you have two options available to you.
• One, to start your own business and earn ZMW100, 000 per annum
or join a company and get ZMW120, 000 per annum.
• So, if you commence your own business you will earn ZMW100, 000
per year, but you will not get ZMW120, 000. This ZMW120, 000 is
your opportunity cost, which is effectively 20,000, which you will
incur for starting your own business.

• Question: What do you call the gain you would obtain if you
joined the company instead of starting your own business?
 Situational Analysis of Opportunity Cost

• After determining your trade-off, a cost can be

assigned to what you have given up.
• Opportunity cost is the value of the alternative you
gave up, plus what your choice costs you.
• If you choose to see your friends, and not see your
parents, you not only give up seeing your parents – a
cost – but you may also spend money while out with
your friends.
• To determine the opportunity cost of a decision, you
add up the costs of passing up the next best alternative
 Calculating Opportunity Cost

• Opportunity cost calculations require looking at decisions in a way

you may not have considered before.
• If you spend $30 while out with friends, but would have spent
nothing seeing your parents, $30 must be added to opportunity
cost.
• Your choice to see your friends therefore cost you the opportunity
of seeing your parents, plus $30, which you could have spent on
something else in the future.
• Calculating your opportunity costs can aid in decision making, as
you will be able to see the effects of your choices.
 Valuation of Opportunity cost
• The opportunity cost of a course of action can
be different for different individuals or entities,
because it is determined by a person’s needs,
wants, money and time.
• Therefore, what is valued more for an
individual than any other thing, vary among
individuals, while deciding the way in which
resources are to be allocated.
 Key Differences Between Trade-off and Opportunity Cost

The difference between trade-off and opportunity cost can be drawn clearly on
the following grounds:
1) The trade-off is a term used to describe the courses of action given up in order
to perform the preferred course of action. Conversely, the opportunity cost is
defined as the cost of opting one course of action and forgoing another
opportunity, to undertake that course of action.
2) Trade-off refers to all the other alternatives which are foregone, to do what we
want. On the contrary, the opportunity cost is the expected return on an
investment, other than the existing one.
3) A trade-off represents, what is renounced, to get what is wanted or desired. In
contrast, opportunity cost represents, what amount could have been received,
if the resources are put to the next-highest-valued alternative.
 Latent and Explicit Costs
4) Every choice you make in life has visible and hidden
costs. Buying a slice of pizza costs you $3, but you
are also giving up the possibility to eat something
else and you can't spend that $3 again. Each choice
made means another alternative has been forgone.
5) A trade-off is isolating what that forgone alternative
is, and opportunity cost involves calculating the cost
of the trade-off. Trade-off and opportunity cost are
therefore linked, with the former helping to
calculate the latter.
 Conclusion

• The concept of scarcity gave birth to the notion of trade-off

and opportunity cost.
• These directly apply the principle of scarcity, as people have
to decide, which one to choose among various alternatives
while spending their time and money.
• The opportunity cost of choosing a project over the other, i.e.
it is the alternative you must give up while making a choice.
• On the other hand, trade-off refers to all the other actions
which we could be doing, apart from what we are doing.