Oppurtunity Cost Approach - Definition, Assumptions and critical analysis

The opportunity cost theory explains that if a country can produce either commodity X or Y, the opportunity cost of commodity X is the amount of the other commodity Y that must be given up in order to get one additional unit of commodity X. Thus, the exchange ratio between the two commodities is expressed in terms of their opportunity cost. The concept of opportunity costs has been illustrated in international trade theory with production possibility curve.

OPPORTUNITY COST APPROACH - ASSUMPTIONS

• There is perfect competition in factor and commodity markets.

• Price = Marginal cost of production for every commodity.

• Factor price = Marginal product of the factor.

.There is condition of full employment equilibrium.

•Supply of factors is fixed.

OPPORTUNITY COST APPROACH - CRITICAL ANALYSIS.

The opportunity cost theory analyses pre-trade and post-trade situation under constant, increasing and decreasing opportunity costs whereas the comparative cost theory is based on the constant costs of production within a country and comparative advantage and disadvantage between the two countries. Thus, the opportunity cost theory is superior to the classical comparative cost theory on analytical grounds. According to Jacob Viner, the opportunity cost approach is inferior as tool of welfare evaluation to the classical real cost approach. Despite these criticisms, the opportunity cost approach has been regarded as a simplified version of a general equilibrium model by Richard Caves. As pointed out by Samuelson "the opportunity cost approach is more fertile because it can be readily extended into a general equilibrium system.