CDS (II) 2021 General Knowledge · Question 48 of 120

Correct — D, Value of next best alternative that is given up. Opportunity cost is what economics substitutes for the accountant's idea of cost. Because resources are scarce, choosing one use of them means abandoning every other use; the cost of the chosen activity is measured by the value of the best of those abandoned uses, and by that one alone. The word next is doing the work. If a person can spend an hour studying, working for two hundred rupees, or sleeping, and ranks the paid work second after studying, then the cost of studying is two hundred rupees — not the sleep as well, and not the sum of both. Measured this way, cost includes things no ledger records, which is why a self-employed shopkeeper's true cost includes the salary he could have earned elsewhere, and why a free public service still costs society something.

• (a)Out of pocket cost — Out-of-pocket cost is the accounting or explicit cost — money actually paid out. It leaves out implicit costs such as forgone earnings or the rent of one's own premises, which is precisely what opportunity cost is designed to capture.
• (b)Out of pocket cost plus cost incurred by the Government — Adding government spending to out-of-pocket cost widens the accounting measure but keeps it an accounting measure. It still counts money spent rather than alternatives surrendered.
• (c)Value of all opportunities forgone — The near-miss the item is built around, and the commonest wrong answer. Alternatives forgone are not added up, because they could not all have been enjoyed at once; only the single best of them measures what the choice cost.

Scarcity forces choice, and choice creates cost. Opportunity cost is the value of the next best alternative sacrificed when a decision is made. It underlies the production possibility curve, where producing more of one good costs output of the other, and it is the reason economists speak of implicit as well as explicit costs.

The examiner's trap here is a plural. All opportunities forgone sounds more thorough and is therefore attractive, but it double-counts: the alternatives are mutually exclusive, so the sacrifice is one of them, the best one. A worked example fixes it — an agricultural labourer earning four hundred rupees a day who turns down a babysitting job at seven hundred has an opportunity cost of seven hundred, the income surrendered, and not eleven hundred. The idea also explains why the notion of a free good is misleading in public finance: when a service is supplied without charge, the resources it uses could have gone elsewhere, and the cost is borne by taxpayers rather than by the user.

• Opportunity cost is the value of the next best alternative forgone, not the sum of all alternatives.
• Explicit or out-of-pocket costs are money actually paid; implicit costs are the value of owned resources used in the activity.
• Economic cost equals explicit plus implicit cost, which is why economic profit is smaller than accounting profit.
• The production possibility curve is a picture of opportunity cost — its slope is the rate at which one good must be given up for another.
• A service supplied free by the government still has an opportunity cost, which is transferred from the user to the tax-paying public.

• Adding up every alternative instead of taking the best one.
• Confusing opportunity cost with money spent — the two coincide only when there are no implicit costs.
• Treating a free public service as costless to society.

As a definition item, or as a small numerical scenario in which the candidate has to name the income or output surrendered.

• practice — not a real PYQ

  A shopkeeper runs his business in premises he owns and draws no salary. In computing economic cost, the rent he could have earned on the premises is

  • (a)ignored, since no rent is actually paid
  • (b)an implicit cost and part of opportunity cost
  • (c)a sunk cost
  • (d)an explicit cost

  Answer(b) an implicit cost and part of opportunity cost — economic cost adds the value of owned resources used in the business to the money actually paid out.

• practice — not a real PYQ

  The slope of a production possibility curve measures

  • (a)the rate of inflation
  • (b)the opportunity cost of one good in terms of the other
  • (c)the level of unemployment
  • (d)the elasticity of demand

  Answer(b) the opportunity cost of one good in terms of the other — how much of one must be surrendered to produce one more unit of the other.