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opportunity costs

Robert E. McAuliffe


Opportunity costs are fundamental to economics, yet they are frequently overlooked in practice. The opportunity cost of any decision or choice made by consumers or firms is the value of the next best choice that was sacrificed. For example, consider a division within a firm that produces computer chips which are used by another division to assemble computers. The computer‐assembly division would prefer to obtain the chips at the production cost of the manufacturing division (say, $100 per chip) to increase its profits. However, if those chips can be sold in the market at $250 per chip, then every internal sale of chips to the assembly division has an opportunity cost of $250 to the company, the revenue the company could earn if the chips were sold in the market (see Shughart, Chappell, and Cottle, 1994 , for their discussion of internal transfer pricing between divisions). Opportunity costs are also important for a company's long run planning. If the computer company in the example above earns a 10 percent return on the capital it has invested in computer assembly but could earn 15 percent elsewhere, then this company should leave this industry in the long run because the opportunity cost of investment capital is not covered. Since this company could earn 15 percent investing its capital in another industry, in the long run it should exit the computer assembly industry. The distinction ... log in or subscribe to read full text

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