IGCSE Economics 0455: Opportunity Cost for Consumers, Firms and Government

Opportunity cost applies to every decision-maker in an economy. Read the three situations below.

Situation 1 (consumer): Devan has $60 of birthday money. He can afford to buy either a skateboard or a video game console accessory, both priced at $60, but not both. He buys the skateboard.

Situation 2 (firm): Wheelworks, a bicycle repair shop, has one mechanic free for the afternoon. The mechanic could repair a customer's bicycle for a $45 fee, or service a delivery van under a maintenance contract worth $60. Wheelworks chooses to service the delivery van.

Situation 3 (government): The government of Velora has one grant of $5 million to spend this year. It can use the whole grant either to build 25 km of new rural road, or to renovate a hospital wing that would add 40 hospital beds. It chooses to renovate the hospital wing.

(a) State the opportunity cost of Devan's decision to buy the skateboard. [1]

(b) State the opportunity cost of Wheelworks' decision to service the delivery van. [1]

(c) Explain the opportunity cost of Velora's government decision to renovate the hospital wing, and explain why simply stating this opportunity cost as $5 million would not be a fully correct answer. [5]

Part (a): The consumer’s opportunity cost

Devan has $60 and can only afford one of the two goods on offer. By buying the skateboard, he gives up the chance to buy the video game console accessory instead. Since both goods cost the same $60 and there was no other alternative on offer, the console accessory is the single next best alternative Devan sacrifices. That is his opportunity cost, not simply “$60”, which is only the amount he spends either way.

Part (b): The firm’s opportunity cost

Wheelworks has one mechanic free for the afternoon and must choose between two paid jobs. By servicing the delivery van, the mechanic’s time is no longer available to repair the customer’s bicycle. The next best alternative given up is therefore the $45 repair fee: even though the chosen job (the $60 van contract) is worth more, Wheelworks still sacrifices the opportunity to earn the $45 fee from the job not taken, and that $45 is its opportunity cost.

Part (c): The government’s opportunity cost, in real terms

Velora’s government has one grant of $5 million and must choose between two specific projects: 25 km of rural road, or a hospital-wing renovation adding 40 beds. By renovating the hospital wing, the government gives up building the 25 km of road. That road is the real, next best alternative use of the same grant.

It might seem tempting to answer that the opportunity cost is “$5 million”, since that is the size of the grant. This is not a fully correct answer, because the $5 million is spent either way. Whichever project Velora’s government had chosen, the same $5 million would have been used. Simply repeating the size of the grant tells us nothing about what is actually given up.

The genuine opportunity cost is the specific real alternative that the money would otherwise have produced: the 25 km of road (and the improved transport access it would have provided to the areas it would have served) that Velora’s government will now not get, because the same scarce grant has been committed to the hospital wing instead.

Final answers

(a) Devan’s opportunity cost is the video game console accessory he gives up by buying the skateboard.
(b) Wheelworks’ opportunity cost is the $45 bicycle-repair fee it gives up by servicing the delivery van instead.
(c) Velora’s government’s opportunity cost is the 25 km of rural road it gives up by renovating the hospital wing; stating it as “$5 million” is incomplete because that money is spent regardless of which project is chosen, so only naming the real alternative (the road) identifies what is genuinely sacrificed.