Fundamental concepts II: opportunity cost and the equimarginal principle
Managerial Economics · Unit I · Topic 3 of 15 · 5 min read
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1. Opportunity cost: meaning
Resources are scarce and have alternative uses. When a resource is put to one use, the other uses are given up. The opportunity cost of a decision is the value of the next best alternative foregone. The concept was developed by the Austrian economist Friedrich von Wieser, and is also called alternative cost or transfer cost.
Benham: the opportunity cost of anything is “the next best alternative that could be produced instead by the same factors or by an equivalent group of factors costing the same amount of money.”
The principle for decisions: a decision is sound only if the return from the chosen use is at least equal to the return from the best alternative use. Opportunity cost is the true economic cost, whether or not money is paid for it.
2. Features
- It is the next best alternative only, not the sum of all alternatives foregone.
- It may involve no cash outlay. The owner’s own capital, own building and own labour cost nothing in the books, but each has an opportunity cost (interest, rent, salary foregone). These are the implicit costs of Unit III.
- It exists only where resources have alternative uses. A specific resource with only one use (a specialised machine with no resale value) has zero opportunity cost.
- It is a decision cost, not a historical cost. It looks forward, at what will be given up, not back at what was paid.
3. Uses in managerial decisions
- Measuring economic profit (accounting profit less implicit costs) rather than book profit.
- Choosing among projects, products or markets.
- Deciding whether to make or buy, own or lease.
- Fixing factor prices: a worker must be paid at least what he can earn elsewhere (transfer earnings).
- Valuing idle resources: idle capacity has a low opportunity cost, which is why a special order at a low price may be accepted.
4. Worked problems on opportunity cost
Problem 1 (accounting versus economic profit). Ravi leaves a job paying Rs. 4,00,000 a year to run a shop in a building he owns, which he could let for Rs. 2,00,000 a year. He puts in Rs. 10,00,000 of his own savings, which could earn 8% in a bank deposit. The shop’s accounting profit is Rs. 6,50,000. Is the business worth running?
| Item | Rs. |
|---|---|
| Accounting profit | 6,50,000 |
| Less: salary foregone | 4,00,000 |
| Less: rent foregone | 2,00,000 |
| Less: interest foregone (8% of 10,00,000) | 80,000 |
| Economic profit (loss) | (30,000) |
The books show a profit of Rs. 6,50,000, but the shop earns Rs. 30,000 less than Ravi’s resources would earn elsewhere. On economic grounds he should return to his job, let the building and deposit the money, unless there are non-money reasons to stay.
Problem 2 (choice of project). A firm with Rs. 50 lakh can invest in project A (expected return Rs. 6 lakh), project B (Rs. 5 lakh) or project C (Rs. 4.5 lakh). If it chooses A, the opportunity cost is Rs. 5 lakh (the best alternative, B), not Rs. 9.5 lakh (B + C), and the economic gain from choosing A is Rs. 1 lakh.
Problem 3 (idle machine). A machine bought for Rs. 3,00,000 is idle. It can be sold for Rs. 40,000, or used for a job that brings incremental revenue of Rs. 1,00,000 with incremental cash costs of Rs. 70,000. The relevant cost of using the machine is Rs. 40,000 (sale value foregone), not Rs. 3,00,000 (sunk). Gain from the job = 1,00,000 − 70,000 − 40,000 = Rs. −10,000. Sell the machine.
5. The equimarginal principle
The law of equimarginal utility is associated with H.H. Gossen (Gossen’s second law) and was developed by Marshall. For a consumer: a given income gives maximum satisfaction when it is spent so that the marginal utility of the last rupee is the same in every use:
MUA/PA = MUB/PB = … = MU of money.
Managerial version. A firm has limited resources (funds, labour hours, machine time) to divide among activities, departments or products. Total return is greatest when the resource is allocated so that the marginal return from the last unit is equal in every use. If the last rupee in advertising earns more than the last rupee in the sales force, shift money from the sales force to advertising until the two are equal.
6. Worked problem on the equimarginal principle
A firm has Rs. 5 lakh to divide between advertising (A) and the sales force (B), in units of Rs. 1 lakh. The additional revenue from each successive lakh is:
| Lakh spent | 1st | 2nd | 3rd | 4th | 5th |
|---|---|---|---|---|---|
| A: marginal return | 50 | 40 | 30 | 20 | 10 |
| B: marginal return | 45 | 30 | 20 | 10 | 5 |
Allocate each lakh to the use with the higher marginal return: 1st to A (50), 2nd to B (45), 3rd to A (40), 4th and 5th to A (30) and B (30). Result: A gets Rs. 3 lakh, B gets Rs. 2 lakh, and the last lakh in each earns 30. Total return = (50 + 40 + 30) + (45 + 30) = 195. Any other split earns less: A 4, B 1 gives 50 + 40 + 30 + 20 + 45 = 185.
7. Limitations of the equimarginal principle
- Marginal returns are hard to measure in practice, especially for activities such as research or goodwill advertising.
- Resources are often indivisible: one cannot hire half a salesman.
- Returns arise over time, so they must be discounted before they are compared.
- Human behaviour (habit, inertia) and legal or contractual commitments prevent continuous re-allocation.
How this is examined
“Principle of opportunity cost” was the 6-mark note in February 2025 and August 2024, and “Law of equi-marginal” in August 2024. Either can also form part of an essay on the fundamental concepts. For the note, give the definition, the decision rule, two features and a small table. Where a problem is set, state the alternatives, pick the next best, and give the economic profit or the allocation with its total.
Now try the real questions: Managerial Economics past question papers.