Friday, June 12, 2009

Opportunity cost principle, Equi-marginal principle

Write short notes on:
a. Opportunity cost principle
b. Equi-marginal principle
Illustrate your answers with examples.

(a) Opportunity cost principle
Opportunity costs are cash outflows prevented by taking one course of action instead
of another. They include returns, which the entrepreneur could have earned in
alternative use of his services and capital.
The concept of opportunity cost occupies a very important place in modern economic
analysis. The opportunity costs or alternative costs are the return from the second best
use of the firm’s resources which the firm forgoes in order to avail itself of the return
from the best use of the resources. To take an example, a farmer who is producing
wheat can also produce potatoes with the same factors. Therefore, the opportunity cost
of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that
opportunity cost of anything is the next best alternative that could be produced instead
by the same factors or by an equivalent group of factors, costing the same amount of
money. Two points must be noted in this definition. Firstly, the opportunity cost of
anything is only the next best alternative foregone. Secondly, in the above definition is
the addition of the qualification or by an equivalent group of factors costing the same
amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to
produce a good the producer has to employ various factors of production and have to
pay them sufficient prices to get their services. These factors have alternative uses.
The factor must be paid atleast the price they are able to obtain in the alternative uses.
Suppose a businessman can buy either a washing machine or a press machine with his
limited resources and suppose that he can earn annually Rs. 40,000 and 60,000
respectively from the two alternatives. A rational businessman will certainly buy a press
machine that gives him a higher return. But, in the process of earning Rs. 60,000 he
has foregone the opportunity to earn Rs. 40,000 annually from the washing machine.
Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between
actual and opportunity costs is called economic rent or economic rent or economic
profit. For example, economic profit from press machine in the above case is Rs.
60,000 –Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational
to invest resources in press machine.
(b) Equi-marginal principle
The equi-marginal principle was originally associated with consumption theory and the
law is called ‘the law of equi-marginal utility’. The law of equi-marginal utility states that
a utility maximizing consumer distributes his consumption expenditure between various
goods and services he/she consumes in such a way that the marginal utility derived
from each unit of expenditure on various goods and services is the same. The pattern
of consumer’s expenditure maximizes a consumer’s total utility.
The law of equi-marginal principle has been applied to the allocation of resources
between their alternative uses with a view to maximizing profit in case a firm carries out
more than one business activity. This principle suggests that available resources
(inputs) should be so allocated between the alternative options that the marginal
productivity gain (MP) from the various activities are equalized. For example, suppose
a firm has a total capital of Rs. 100 million which it has the option of spending on three
projects, A, B, and C. Each of these projects requires a unit expenditure of Rs. 10
million. Suppose also that the marginal productivity schedule of each unit of
expenditure on the three projects is given as shown in the following table.
Units of Expenditure Marginal Productivity (MP)
(Rs. 10 million) Project A Project B Project C
1st 501 403 354
2nd 452 305 306
3rd 357 208 209
4th 2010 10 15
5th 10 0 12
Going by the equi-marginal principle, the firm will allocate its total resource (Rs. 100
million) among the projects A, B and C in such a way that marginal product of each
project is the same i.e., MpA = MPB = MPC. It can be seen from the above table that
going, by this rule, the firm will spend 1st, 2nd, 7th, and 10th unit of finance on project A,
3rd, 5th, and 8th unit on Project B, and 4th, 6th, and 9th unit on project C. In all, it puts 4
units of its finances in project A, 3 units each in projects n and C. In other words, of the
total finances of Rs. 100 million, a profit maximization firm would invest rs. 40 million in
project A, Rs. 30 million each in projects B and C. This pattern of investment maximizes
the form’s productivity gains. No other pattern will ensure this objective.
The equi-marginal principle suggests that a profit maximizing firms allocates
MpA = MPB = MPC = … = MPN
If cost of project (COP) varies from project to project, then resources are so allocated
that MP per unit of COP is the same. That is, resources are are allocated in such
proportions that
The equi-marginal principle can be applied only where (i) firms have limited investible
resources, (ii) resources have alternative uses, and (iii) the investment in various
alternative uses is subject to diminishing marginal productivity or returns.