Why does increasing opportunity cost occur

Any business tries to use its resources efficiently. No one has unlimited resources, so it's critical that you make smart choices about using what you do have. Those decisions are influenced by what economists call opportunity cost. And as you commit more resources to a particular task, you'll run into the law of increasing opportunity costs in your small business.

When people talk about "cost," they tend to think in terms of accounting cost – the dollars spent on something. If your business chooses to spend $1,000 on a computer, for example, then the accounting cost is $1,000. But your purchase also comes with opportunity cost. By buying the computer, you're giving up the chance to do something else with that $1,000. That "something else," whatever it is, is the opportunity cost. The the total cost of using something the highest cost of the best alternative use, says The Library of Economics and Liberty. Finding the best use for money is often an exercise in identifying the use that carries the lowest opportunity cost.

Opportunity cost exists even when you're not spending money. Say you own a store. If you assign an employee to straighten up the stockroom rather than help customers, that might cost you a few sales, since some customers might not be helped and will leave without buying anything. On the other hand, if you put her out on the sales floor and the stockroom remains a mess, you may lose other sales because your staff can't locate the merchandise customers want to buy. Either option has an opportunity cost.

The law of increasing opportunity cost says that as you pour more and more of a limited resource into an activity, your opportunity cost gets larger for each additional "unit" of the resource. Say you have five employees working on the sales floor, and you send one to straighten up the stock room. That may cost you a few sales. Send a second worker back there, and you'll lose even more sales than you did with the first worker. For each additional worker you send back, you lose a larger amount of sales revenue as the remaining sales staff gets increasingly overwhelmed and customers leave in frustration.

Imagine you own a small shop that makes belts and hats by hand. Each hat you make and sell brings in $30 in profit, and each belt brings in $20. To make more money, you shift more workers from belt production to hats. Some workers can make a hat just as quickly as a belt, so the opportunity cost it low: You give up $20 to make $30.

But others are belt specialists. It might take them as much time to make one hat as it does to make four belts. With them, the opportunity cost is high: To make $30, you're giving up $80.

Meanwhile, your stepped-up hat production has glutted the hat market, forcing you to cut prices and reduce profit to $25 a hat. The opportunity cost rises further because of the price decrease, likely forcing you to change your strategy.

Opportunity costs exist because of the fact of limited resources, says Shopify. And not all resources are suited to every task. Smart business owners and managers take stock of the resources they have at their disposal and deploy them to ensure the greatest return – that is, to minimize the opportunity cost. But they also understand that opportunity cost is not constant. It rises – slowly at first, but more rapidly later on as you apply resources to tasks for which they're ill-suited and leave other areas neglected.

Making smart decisions is important to avoid increasing opportunity cost over time. Evaluate whether your situation fits into the law of increasing costs examples of the constant opportunity cost graph to decide what will be best not only in the short-term but for your future steps as well.

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Have you been to a frontier lately? Whether you realize it or not, the economy has a frontier—it has an outer limit of economic production. In this episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains how the production possibilities frontier (PPF) illustrates some very important economic concepts.

Segment 3 of The Production Possibilities Frontier uses the production possibilities frontier to demonstrate how, in the real world, opportunity cost increases as production increases. This is a difficult concept made simple using the PPF.

Watch other segments of this episode:

More episodes:

• The Economic Lowdown Podcast Series
• The Economic Lowdown Video Series

Transcript:

Below is the full transcript of this video presentation. It has not been edited for readability, and there may be slight differences between the text and the video.

Our final lesson focuses on the shape of the frontier line. Up to this point we've graphed the PPF as a straight line. However, a straight line doesn't best reflect how the real economy uses resources to produce goods. For this reason, the frontier is usually drawn as a curved line that is concave to the origin. This curved line illustrates our fifth and final lesson.

Lesson 5: The law of increasing opportunity cost: As you increase the production of one good, the opportunity cost to produce the additional good will increase.

First, remember that opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up.

So let's compare straight and curved frontier lines to better understand what is more likely to happen when production changes.

Here's the straight frontier line again.

It shows that Econ Isle can produce a maximum of 12 gadgets and 6 widgets or any other combination along the line.

At this point, Econ Isle can produce 12 gadgets and 0 widgets. This point shows widget production increased by 2, and this by 2 more, and this by 2 more, indicating all widgets and no gadgets.

So along the straight line, each time Econ Isle increases widget production by 2, it loses the opportunity to produce 4 gadgets. This straight frontier line indicates a constant opportunity cost.

In reality, however, opportunity cost doesn't remain constant. As the law says, as you increase the production of one good, the opportunity cost to produce the additional good increases.

If Econ Isle transitions from widget production to gadget production, it must give up an increasing number of widgets to produce the same number of gadgets. In other words, the more gadgets Econ Isle decides to produce, the greater its opportunity cost in terms of widgets.

If Econ Isle's production moved in the opposite direction, from all gadgets to all widgets, the law would still hold: As you increase the production of one good, the opportunity cost to produce the additional good increases.

Why does this happen? Well, some resources are better suited for some tasks than others. For example, many Econ Isle workers are likely very productive gadget makers. In the transition to widget production, workers would likely need training and time to develop the skills required to be as productive at making widgets as making gadgets. As the economy transitions from gadgets to widgets, the gadget workers best suited to widget production would transition first, then the workers less suited, and finally the workers not at all well suited to widget production.

Here's where the curved frontier line comes in. It shows that opportunity cost varies along the frontier.

Let's increase widget production in increments of 2 again until only widgets and no gadgets are produced. But this time we'll consider opportunity cost that varies along the frontier.

This point remains the same. At this point, Econ Isle can produce 12 units of gadgets and 0 widgets.

Here's widget production increased by 2. At this point, Econ Isle can produce 10 gadgets and 2 widgets. It loses the opportunity to produce 2 gadgets. In other words, the opportunity cost of producing 2 widgets is 2 gadgets.

Here's widget production increased by another 2. At this point, if Econ Isle produces 6 gadgets, it can produce only 4 widgets, so it loses the opportunity to produce 4 gadgets. In other words, the opportunity cost of producing 2 widgets is now 4 gadgets.

Finally, increasing by another 2, Econ Isle can produce 0 gadgets and 6 widgets. It loses the opportunity to produce 6 gadgets. In other words, the opportunity cost of producing 2 widgets is now 6 gadgets.

Although the production possibilities frontier—the PPF—is a simple economic model, it's a great tool for illustrating some very important economic lessons: The frontier line illustrates scarcity—because it shows the limits of how much can be produced with the given resources. Any time you move from one point to another on the line, opportunity cost is revealed—that is, what you must give up to gain something else. Points within the frontier indicate resources that are underemployed. In turn, movement from a point of underemployment toward the frontier indicates economic expansion. When the frontier line itself moves, economic growth is under way. And finally, the curved line of the frontier illustrates the law of increasing opportunity cost meaning that an increase in the production of one good brings about increasing losses of the other good because resources are not suited for all tasks.

I hope you have enjoyed your journey to the frontier and learned some valuable lessons about economics along the way.

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