Marginal Opportunity Cost: Definition & Formula

Marginal Opportunity Cost: Definition & Formula
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Lesson Transcript
Instructor: Tara Schofield
This lesson reviews marginal opportunity costs. Marginal opportunity costs are explained and illustrated in two easy-to-understand examples with real-life applications.

What Is Marginal Opportunity Cost?

Marginal opportunity cost is an economic term that analyzes the effect of producing additional units of a product on the costs of a business, as well as the opportunities the companies give up to produce more of a product. It sounds complicated, but let's break it down to understandable terms.

Let's say you own a doughnut shop that is very busy. You arrive at 4:00 am to start baking doughnuts to ensure you will have a wide selection for your customers when they start walking through the door at 7:00 am. You frantically create 10 different types of doughnuts between 4:00 and 7:00 am because you know the demand will be high and you will sell out of all of your doughnuts by 11:00 am.

Recently, one of your customers suggested you either offer bagels or make more doughnuts because the you sell out so quickly. You give it some thought and put some numbers together to help you make a decision.

You currently sell $500 in doughnuts every day. If you hire another person to help you make more doughnuts, you can increase your sales to $550 per day. You also consider that you will spend more on flour, sugar, and other baking supplies. The opportunity cost of earning the extra $50 in doughnut sales is the cost of the extra supplies you will use to make the additional doughnuts, payroll expenses to hire another person, and the lost opportunity from not being able to sell bagels. All of these factors must be considered when determining if the marginal opportunity cost is worth the trade-off. To help you through this process, we'll discuss the process of figuring out the marginal opportunity cost.

Calculations

There are three steps to determining a marginal opportunity cost:

1. What does it cost to add additional production?

If you know your current costs for producing a product, the first step is determining how much it will cost to produce additional quantities of that product. In this doughnut shop example, you know how much it currently costs to make doughnuts now. You have enough time and supplies to make doughnuts yourself every day. However, if you decide to make more doughnuts or add another product, you will need to add another person and order additional supplies. Therefore, the income of producing the additional doughnuts may or may not be worth effort after you figure out how much it will cost to produce more doughnuts than you are currently making.

2. Are there other opportunities?

You start thinking about other options you have to grow your business. Continuing with the doughnut shop example, you are now considering adding bagels to your selection. After doing research, you realize you could be making an extra $200 a week if you started selling bagels. Part of considering opportunities is comparing which option will bring in the greatest amount of profit after added expenses are paid.

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