Opportunity Cost & Marginal Analysis
Introduction & Exercises
Opportunity Cost
Opportunity cost is a critical concept in economics and management. It serves as your guide to making the best decisions possible. The object of management is to minimize your opportunity cost. So what is opportunity cost? Opportunity cost is the reward (money, time, satisfaction, etc.) that you could have received from the next best use of a resource (time, fertilizer, money, etc.). That is, what did you have to give up in order to do something. The textbook definition of opportunity cost is “the income that could be received by employing a resource in its next best use (or the most profitable alternative). As a simple example, assume you have $1,000 you can invest in a savings account that earns 3 percent annually, or in mutual funds which earn 10 percent annually. If you put your money in the savings account, your opportunity cost is the $100 you could have earned by investing in the mutual funds. If you invest in the mutual funds, your opportunity cost is the $30 you could earn by investing in the savings account. To minimize your opportunity cost, the best decision in this example is to invest in mutual funds. This would result in an opportunity cost of $30 rather than $100 if you invested in the savings account. To make the concept more realistic, assume you want to have quick and easy access to your money. The savings account provides this access, whereas the mutual funds may not. In this case, the opportunity cost of investing in mutual funds is $30 plus the loss of easy access to your money. As a manager, you need to decide whether this loss of access is worth more than $70 ($100 - $30) to you. If it is worth more than $70, your best decision (which minimizes opportunity cost) is to invest in the savings account. Easy enough, right? As another example, assume you have $10,000 that you could invest in machinery for your business or you could invest the money in mutual funds. What is the best use of this money? By investing the money in machinery you estimate you could improve your production process, earn a return of 8 percent, and you really would like to own the new machinery; investment in mutual funds could earn a rate of 10 percent. What is the opportunity cost related to these decisions? If you invest in machinery you are foregoing earnings of $1,000 from the mutual funds; thus, your opportunity cost is $1,000. If you invest in mutual funds you forego earnings of $800, the satisfaction of knowing you improved your operation, and the satisfaction of owning the new machinery (can you put a dollar figure on the satisfaction you would get from owning new machinery?).
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Opportunity Cost & Marginal Analysis
Introduction & Exercises
Your job as manager is to decide whether the satisfaction you might get from improving your operation and owning the machinery is greater than or less than the $200 ($1,000 - $800) difference in lost earnings by investing in the machinery. If it is greater than $200, then you can feel comfortable about buying the machinery; otherwise, the mutual funds are the more economically-correct investment. Other agricultural examples of opportunity cost include: 1) Going to college vs. going to work after graduating from high school 2) Managing your own business vs. working for someone else’s business
3) Selling hay you produced vs. feeding the hay to your cow herd
4) Planting corn vs. planting soybeans
5) Planting crops on your land vs. renting your land to your neighbor.
6) Propagating tomato plants instead of annuals in your greenhouse
7) Selling your calves now vs. adding another 200 pounds of gain
8) Selling your timber for sawn boards vs. veneer vs. pulp
9) Claiming the lowest number of exemptions on your W-2 (getting as much as possible withheld from your paycheck) vs. claiming a higher number of exemptions on your W-2 (having less money withheld from your paycheck)
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Opportunity Cost & Marginal Analysis
Introduction & Exercises
Opportunity Cost Exercise
Comparing Opportunity Cost of Selected Crops A farmer has a 100-acre field and the equipment to produce corn, oats, barley, or soybeans. Calculate the opportunity cost of growing each of these crops and decide which one you think the farmer should plant. Corn Per-acre production costs Selling price per bushel Yield per acre Oats Per-acre production costs Selling price per bushel Yield per acre Barley Per-acre production costs Selling price per bushel Yield per acre Soybeans Per-acre production costs Selling price per bushel Yield per acre
$140/acre $3.50/bu. 110 bu/acre
$40/acre $2.10/bu. 60 bu/acre
$40/acre $1.60/bu. 95 bu/acre
$90/acre $8.00/bu. 36 bu/acre
Comparing Opportunity Cost of Selected Crops (Per Acre)
Item
Corn
Oats
Barley
Soybeans
Total Income/Acre
Total Prod. Costs/Acre
Net Profit/Acre
Opportunity Cost/Acre
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Opportunity Cost & Marginal Analysis
Introduction & Exercises
Marginal Analysis Marginal analysis is a powerful tool to help you allocate your resources in the most profitable manner. The main idea of marginal analysis is to allocate the resource (input) to the enterprise (or use) that provides the greatest return (in dollars). In other words, you allocate the resource so that you minimize your opportunity costs. You continue to do this as long as the added return (marginal revenue) is greater than the added cost (marginal cost) of the resource. You should stop as soon as the added cost of using the input is just equal to the added return of using the input. A silly example of marginal analysis revolves around “The Stupid Bank Teller”. Assume you have a $10-bill and you want to get ten $1-bills instead. So you go to the local bank and ask for change. You give the teller your $10-bill and the teller gives you ten $10-bills in return. So you do what any red-blooded American would do -- you thank the teller and leave the bank. Here’s the marginal analysis so far -- your marginal cost was $10 (you gave the teller a $10-bill). Your marginal revenue is $100 (ten $10-bills). Your profit is $90. Since you made out so well at the bank, you decide to go back to the same teller and try it again. This time you give the teller a $10-bill and the teller makes a mistake -- he only gives you eight $10-bills in return. So you do what any red-blooded American would do -- you thank the teller and leave the bank. The marginal analysis -- your marginal cost is $10. Your marginal revenue is $80, so your profit on this trip to the bank is only $70. That’s less than the $90 profit you made last time, so you should quit right? Your profits are decreasing, right? WRONG. Your total profit so far is $160 ($90 + $70). That’s right, since the marginal revenue is greater than the marginal cost, your total profits increased! On the next trip the teller only gives you four $10-bills. The next trip you only get two $10-bills as change for your $10-bill. On your next trip, to your horror, the teller, who is slowly catching on, only gives you ten $1-bills as change for your $10-bill. At this point, your marginal cost ($10) is just equal to your marginal revenue ($10), so you should quit your little game. You have maximized your profits. One problem students have in marginal analysis deals with decreasing marginal returns. For example, in “The Stupid Bank Teller” example your marginal revenue decreases from $100 to $80 to $40 to $20 and finally to $10. Some people say, why not quit when your marginal revenue is $100. That’s greater than $80, right. True, but these are marginal revenue, not total revenue. If you add all of your marginal revenues, you will get your total revenues. So even though the marginal revenue drops from $100 to $80, your total revenues have increased by $80! Check the math -- while your marginal revenues drop by $20, your profits have increased from $90 to $160. Personally, I’d rather have the $160 total profit than the $100 marginal revenue.
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Opportunity Cost & Marginal Analysis
Introduction & Exercises
Marginal Analysis & The Stupid Bank Teller
Added Cost (Marginal Cost) $10 $10 $10 $10 $10
Added Revenue (Marginal Revenue) $100 $80 $40 $20 $10
Added Profit (Marginal Profit) $90 $70 $30 $10 $0
Total Profit
$90 $160 $190 $200 $200
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Opportunity Cost & Marginal Analysis Example of Marginal Analysis
Introduction & Exercises
Farmer Anne has 8,000 pounds of fertilizer that she can apply either to her corn, soybean, or alfalfa hay fields. Each field is 50 acres in size. The cost of fertilizer is $0.50/lb. Adding extra fertilizer to each crop will increase the yield (to a certain point), thus increasing Anne’s returns. Use the following information to help Anne allocate fertilizer. Corn price = $3.50/bu. Soybean price = $8.00/bu Alfalfa price = $150/ton (roughly $3.75/bale) Added Fertilizer (lbs./Acre) Total Added 20 20 40 60 80 100 20 20 20 20 Added Production Soybeans Added (bu/A) Return 10 8 5 1 -1
Corn (bu/A) 14 8 5 2 -2
Added Return
Alfalfa (tons/A) 1.0 0.6 0.4 0.25 0.1
Added Return
A. What is the added cost per acre of applying an extra 20 lbs./A of fertilizer on any of these fields?
B. Assume Anne only has 1,000 pounds of fertilizer. Remember, each field is 50 acres, so that equals 20 lbs/acre. On which field should she spread the fertilizer? Why did you choose this field?
C. Anne can get another 1,000 pounds of fertilizer. On which field should she spread this 1,000 pounds? Why
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Opportunity Cost & Marginal Analysis
Introduction & Exercises
D. Now assume Anne has the entire 8,000 pounds of fertilizer. What is the most profitable allocation of this fertilizer on her three fields? How much profit can Anne expect from this allocation?
Corn
Soybeans
Alfalfa Hay
E. How much would Anne be willing to pay for an additional 1,000 pounds of fertilizer (an extra 20 lbs/acre)? How did you get this number?
F. Anne has talked to her lender and has obtained an operating loan for fertilizer. Now she can buy all of the fertilizer she wants. How much should she buy, and how should she allocate this amount? Corn Soybeans Alfalfa Hay
G. What is your “decision rule” in marginal analysis?
H. How can you apply marginal analysis to everyday life? to sports? to other activities?
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