Unit 3

Engineering Economics

Opportunity Cost: Comparison and Alternatives

Definition:

Opportunity cost refers to the value of the next best alternative that must be forgone when a
choice is made. In simpler terms, it's the cost of what you're giving up to do something else. It
plays a crucial role in decision-making as it helps in comparing various alternatives.

Key Concepts:

1. Scarcity of Resources: Resources like time, money, labor, and raw materials are
limited. This scarcity forces individuals, businesses, and governments to make
choices on how best to allocate them.
2. Trade-offs: Every decision involves choosing one option over another. The trade-off
is what is given up in terms of potential gain from other alternatives.
3. Explicit vs Implicit Costs:
o Explicit Costs: Direct monetary expenses, like buying equipment or paying
wages.
o Implicit Costs: Indirect costs that are harder to measure, such as the value of
the time or resources you could have used elsewhere.
4. Sunk Costs: These are past costs that have already been incurred and cannot be
recovered. Sunk costs should not be considered when making future decisions
because they do not affect opportunity cost.

Opportunity Cost in Decision-Making

1. Individual Level:
o Time: Imagine you have two hours of free time. You can either study for an
exam or watch a movie. If you choose to watch the movie, the opportunity
cost is the lost time that could have been spent studying, which may impact
your exam performance.
o Money: You have $100 and decide to spend it on a concert ticket. The
opportunity cost could be other things you might have bought or saved the
money for, like buying a book or investing.
2. Business Level:
o Investment Decisions: A company may choose between investing in new
machinery or expanding its marketing campaign. If it chooses to invest in
machinery, the opportunity cost is the potential increased sales from the
marketing campaign.
o Production Choices: A factory that produces cars must decide whether to
dedicate resources to producing more sedans or trucks. The opportunity cost of
choosing sedans over trucks is the potential profit from producing trucks
instead.
 3. Government Level:
o Public Spending: A government might need to choose between funding
healthcare or education. If they allocate more funds to healthcare, the
opportunity cost is the potential benefits from an improved education system.

How to Measure Opportunity Cost

1. Cost-Benefit Analysis: A method used to compare the potential benefits of an action

against the costs of the alternatives.
o Example: A student deciding whether to take a gap year before college must
weigh the potential personal growth and work experience against the
opportunity cost of lost academic time.
2. Marginal Analysis: Involves looking at the additional benefits and costs of a
decision. Economists often compare marginal benefits to marginal costs to determine
if the decision is worth it.
o Example: A firm deciding whether to hire one more worker will compare the
additional worker's productivity (marginal benefit) with the additional cost of
hiring them (marginal cost).

Examples of Opportunity Cost

1. Personal Example:
o Suppose you have two options: work at a job that pays $15 per hour or start
your own business, where the potential is higher but less guaranteed. If you
choose the job, the opportunity cost is the potential profit and flexibility from
the business. Conversely, if you start the business, your opportunity cost is the
steady income and security of the job.
2. Educational Example:
o A student considering whether to pursue a higher education degree or enter the
workforce must consider the opportunity cost of forgone wages during the
study period versus the potential increased earnings after graduation.
3. Business Example:
o A restaurant owner can either invest $10,000 in upgrading the kitchen or
opening a new branch. If they upgrade the kitchen, the opportunity cost is the
potential revenue from the new branch.

Comparison of Alternatives:

When comparing different alternatives, it’s crucial to look at:

1. Monetary Gains: What financial benefits or profits could you earn from each
alternative?
2. Non-monetary Gains: Consider factors like personal satisfaction, skill development,
long-term career growth, and societal impact.
 3. Risk: Some choices involve higher risk. High-risk alternatives may have a higher
potential return but come with a higher opportunity cost if they fail.
4. Time: Some alternatives may take longer to deliver returns. The opportunity cost may
include the delayed benefits from other choices.
5. Resources: How resource-intensive is each alternative? Consider the impact on time,
labor, and capital.

Opportunity Cost in Everyday Life

1. Career Choices: Choosing one job over another based on salary, work-life balance,
and personal interest involves analyzing the opportunity cost of the alternative.
2. Buying Decisions: Deciding whether to buy a new phone or save for a vacation
involves weighing the opportunity cost of immediate versus future satisfaction.
3. Leisure vs. Work: Spending more time at work may lead to higher income, but the
opportunity cost could be the time lost for relaxation, hobbies, or spending time with
family.

Conclusion:

Opportunity cost is an essential concept for making informed decisions. By considering the
value of alternatives, individuals, businesses, and governments can allocate resources more
efficiently, prioritize actions, and maximize potential benefits. Recognizing opportunity cost
leads to better choices, whether in everyday personal decisions or large-scale economic
policies.

Cost Benefit Analysis

1. Definition

Cost-Benefit Analysis (CBA) is a systematic process used to evaluate the strengths and
weaknesses of alternatives. It involves comparing the total expected costs of a project or
decision against the total expected benefits, to determine whether the benefits outweigh the
costs and by how much. The goal is to provide a clear framework for decision-making,
particularly for public sector projects or long-term investments.

2. Steps in Conducting Cost-Benefit Analysis

1. Identify the Costs and Benefits:

o All direct and indirect costs and benefits should be identified. These could
include:
 Direct Costs: Wages, materials, capital equipment.
 Indirect Costs: Overheads, opportunity costs, externalities.
Direct Benefits: Revenue generation, cost savings.
Indirect Benefits: Improved public health, environmental quality.
2. Monetize the Costs and Benefits:
o Assign a monetary value to each identified cost and benefit. This can be
complex, particularly for non-market goods like environmental impacts or
public health improvements.

Example: For an infrastructure project like building a highway, direct costs would
include construction materials and labor, while benefits could include reduced travel
time, lower vehicle maintenance costs, and increased economic activity along the
route.

3. Discount the Costs and Benefits:

o Future costs and benefits should be discounted to their present value. This is
because money has a time value; benefits (or costs) that occur in the future are
worth less than those that occur today.

Formula:

PV=FV/(1+r)n

Where:

o PV = Present Value
o FV = Future Value
o r = Discount rate
o n = Number of periods

Example: For a project expected to yield benefits over the next 10 years, a discount
rate (e.g., 5%) will reduce the value of those future benefits when compared to the
costs incurred today.

4. Compare Costs and Benefits:

o Once costs and benefits are discounted to the present value, compare them. A
project is viable if the Net Present Value (NPV) is positive.

NPV = Total Present Value of Benefits − Total Present Value of Costs

A positive NPV suggests the benefits exceed the costs, while a negative NPV suggests
the costs outweigh the benefits.

3. Key Considerations in CBA

 Time Horizon: Long-term projects may have benefits or costs far into the future,
which makes discounting crucial.
 Risk and Uncertainty: Future costs and benefits are uncertain. Risk analysis (e.g.,
sensitivity analysis, scenario planning) is often incorporated into CBAs.
  Intangible Costs/Benefits: Some costs and benefits cannot be easily monetized, such
as environmental impact or quality of life improvements. Methods like contingent
valuation or hedonic pricing are used to estimate these.

4. Examples of Cost-Benefit Analysis

o Air Act, the U.S. economy reaped $30 in benefits, largely due to
improvements in public health.

6. Challenges and Limitations of CBA

 Valuing Non-Market Goods: Putting a price on social and environmental impacts

can be difficult and subjective.
 Discount Rate Selection: The chosen discount rate can significantly affect the
outcome of a CBA. A higher discount rate decreases the value of future benefits.
 Distributional Impacts: CBA typically focuses on aggregate benefits and costs but
may ignore how those benefits and costs are distributed among different groups (e.g.,
low-income communities may bear more costs in some projects).
 Uncertainty and Risk: Predicting future costs and benefits involves a level of
uncertainty, which can lead to inaccurate results if not properly accounted for.

Example:

Building a Wind Farm for Renewable Energy

Step 1: Identify the Costs and Benefits

 Costs:
o Initial Construction Costs: Costs to build and install the wind turbines.
o Maintenance Costs: Annual costs to maintain and operate the wind farm.
o Land Leasing Costs: Annual costs for leasing the land for the wind farm.
 Benefits:
o Revenue from Selling Electricity: Income generated by selling the electricity to the
grid.
o Environmental Benefits: Reduction in carbon emissions and environmental impact.
o Energy Cost Savings: Savings on energy compared to traditional energy sources.

Step 2: Monetize the Costs and Benefits

Let’s assume the following:

 Costs:
o Initial Construction Costs: $10 million
o Annual Maintenance Costs: $500,000 per year
o Annual Land Leasing Costs: $100,000 per year
 Benefits:
o Revenue from Selling Electricity: $3 million per year
o Environmental Benefits: Valued at $200,000 per year in reduced carbon emissions.
 o Energy Cost Savings: $400,000 per year from cheaper energy compared to fossil
fuels.

Step 3: Discount the Costs and Benefits

Assume the project will last for 10 years, and the discount rate is 5%.

 Formula for Present Value (PV): PV=FV/(1+r)n

 Where:
o FV = Cost or benefit in future
o r = Discount rate (5% or 0.05)
o t = Number of years
Conclusion:

Since the Net Present Value (NPV) is positive ($13,165,100), the project is profitable and
worth pursuing. The benefits from the wind farm, when discounted to present values, exceed
the costs by a significant margin.

This process of CBA helps in making informed decisions by considering both the time value
of money (through discounting) and a thorough comparison of costs and benefits.

7. Conclusion

Cost-Benefit Analysis is a powerful tool for evaluating projects and policies, particularly for
large-scale investments or government programs. While it provides a structured method for
decision-making, it must be applied carefully, with attention to intangible costs, future
uncertainties, and distributional equity.