Opportunity costs are a part of every decision that people make. In the study of economics, a choice means selecting one alternative or option over all other alternatives or options after weighing the benefits and costs of each option. The option with the highest valued net benefit is the best choice.
When a choice is made, that means that all alternative options have to be given up. These are the forgone options. Since other options are forgone, a trade-off is involved.
The opportunity cost of a choice is the value of the next best option that could have been made. It should be emphasized that this definition says “value of the next best option”, not “the sum of the values of all options”. This is because “all other options together” is not a choice. Only one choice out of the options can be made.
Life involves a continuous series of choices. Each choice is not made in a vacuum, but rather becomes an additional choice to all other choices that preceded it. When a choice is being weighed, the benefits and costs that add to the total of all choices is considered. This means that decisions are made "at the margin". Only marginal changes, which are called marginal benefits and marginal costs, need to be considered. This concept hopefully will become clearer, and will prove to be useful in the study of economics, as the concept of opportunity costs is better understood.
Economists have developed a simplified model to illustrate and study this concept. The model is called the Production Possibilities Curve, or PPC. Since real life economies can choose between literally millions of different possible combinations of goods, and people cannot visualize or draw in this many dimensions, the PPC considers only two goods at a time. This simplified model is sufficient to illustrate the concepts involved. Also, the two goods that are considered can be aggregates, such as “defense spending” and “non-defense spending”, if necessary.
The PPC is a graph that shows the various combinations of two goods that a society can produce given the current level of available resources. Any point on the curve represents a combination that is considered efficient in the sense that it utilizes all available resources. There is no way to move away from any point on the curve without giving up something.
Any point inside the curve is considered inefficient because not all available resources are being used: more could be produced without giving up anything.
Any point outside the curve represents a production combination that is impossible to produce given the current level of resources.
The PPC illustrates opportunity costs because it shows the trade-offs that are involved. On the PPC, the only way to produce more of one good is to produce less of the other. Such a change in the combination of the two goods would be shown as a movement from one point on the curve to another point on the curve. The amount of one good that is given up to produce more of the other good is the opportunity cost.
The PPC is not normally shown as a straight line, but rather as a bowed-out (convex) curve. This is due to the concept of increasing opportunity costs. “Increasing opportunity costs” is the concept that as more and more resources are diverted from one activity to the other, the marginal cost of that change in the combination that is produced becomes increasingly higher. This is due to specialization. Not all resources used for an activity are going to be equally specialized. As resources are diverted from one activity, the least specialized (efficient) resources would be taken away first. As more and more resources are taken away, however, the marginal resources diverted are ones that are more and more specialized.
It was noted earlier that points outside the PPC are impossible to reach, given the current state of resources. The only way to produce at such a level would be to increase the level of resources. When that happens, the PPC will shift outward. If the additional resources can be used to produce only one good, then the intercept for only that good changes, and the slope of the curve changes (changing the opportunity cost between the two goods).
The level of resources can be increased in two ways:
More resources (quantity) can be found or created, or
a better way to utilize the resources (technological advances) can be found.
More discussion about opportunity costs can be found in the section about specialization and trade.