We know that the resources are limited compared to our wants. Since our wants are unlimited, we cannot satisfy all of our wants due to resource constraints. So we have to make choices. And in making choices, we are confronted by opportunity costs. The opportunity cost of an action is the best alternative forgone.
If the opportunity cost of a good or service increases, people look for the less costly substitutes-the principle of substitution – and decrease their purchases of the more costly item.
The number of notes and coins that must be given up in exchange for a commodity is its money price.
For example, if $5.00 is to be paid for getting a cup of tea, then $5.00 is the money price of a cup of tea. Similarly, if $1.00 is to be paid for having a banana, then $1.00 is the money price of a banana.
Now think, if you have $5.00 in your pocket, how can you spend this money?
You can buy a cup of tea or 5 pieces of banana. If you buy a cup of tea, then you have to forgo 5 pieces of banana. Here, the opportunity cost of a cup of tea is five pieces of banana.
To calculate the opportunity cost of a cup of tea, we can use the following formula:
The opportunity cost of a cup of tea = Pt / Pb, here;
The ratio mentioned above (Pt/Pb) is called relative price. So, a relative price is an opportunity cost.
In the above example, we have seen that the relative price or the opportunity cost of a cup of tea is expressed in terms of banana pieces.
However, this is not the normal way to express the relative price. The normal way of expressing a relative price is in terms of a basket of all goods and services rather than one particular good or service.
That is, we divide the money price of a good by the money price of a basket of all goods that must be given up to buy it (called a price index):
The opportunity cost of a cup of tea = Pt / Pothers, here;
Therefore, the resulting relative price tells us the opportunity cost of an item in terms of how much of the basket of all goods must be given up to buy it.