Importance of opportunity cost
- Determination of Relative Prices of Goods: Commodities are priced because of their opportunity cost. Since commodities are, scarce ,and have alternative uses, they normally command prices which compensate for the other uses which are foregone. For instance, if the same group of factors can produce either one car or ten bicycles, then the price of one car will tend to be at least ten times that of one bicycle.
- It helps in determining factor prices and resource allocation: The opportunity cost sets the value of a productive factor for its best alternative use. It implies that if a productive factor is to be retained in its next best alternative use; it must be compensated for or paid at least what it can earn from its next best alternative use for instance, if a high school teacher can get an alternative employment in a bank as an officer at a salary of Ug.shs 800,000 per month, the school has to pay at least Ug.shs 800,000 as salary to retain him in the high school.
- Decision Making and Efficient Resource Allocation: The concept of opportunity cost is essential for rational decision-making by the producer. It guides producers when making production decisions such as what to produce, how to produce, for whom to produce etc. Suppose, opportunity cost of I motor car is 10 bicycles. The price of the bicycle is Ug.shs 150,000 while the price of the car isUg.shs 2,000,000; it is worthwhile to produce cars rather than bicycles.Because, if he produces 10 bicycles, he will get Ug.shs 1, 500,000, whereas a car fetches him Ug.shs 2,000,000, that is Ug.shs 500,000 more. This wouldalso mean an efficient resources allocation.
- It helps when deciding on the patterns of consumption and publicexpenditure. A factor owner will decide about the use of economic resourcesin that occupation where its opportunity cost is high. For instance, if an a local economics teacher can get a job in a big company as an economic advisor on a monthly salary of Ug.shs 1,000,000 against Ug.shs800, 000 in a high school, then it is quite likely that he would resign from the school and join the Company. It would also mean a more efficient use of his knowledge and talent, It follows that a resource will always' be used in an occupation where it has a 'high opportunity cost. Thus, the concept of opportunity cost serves as a useful economic tool in analyzing optimum resource allocation and rational decision-making.
- It forms basis for, specialization in international trade based on comparative advantages. Country will specialize in the production of that commodity in which it incurs the least opportunity cost compared to the other.