Economic analysis tools such as opportunity cost vs sunk cost, comparative advantage, and production possibilities frontier help companies make informed decisions and make the best use of limited resources. These tools involve analyzing costs, choosing the most efficient activities, and determining how much of a particular good or service a company can handle under certain conditions.
Economic analysis tools help companies make informed decisions. These tools go beyond the basic management and accounting information common in businesses. Some tools used for economic analysis include opportunity cost versus sunk cost, comparative advantage, and the production possibilities frontier. While many other tools exist and are available, the ones listed above are often part of all types of economic analysis. Using economic theory in making decisions usually allows a company to make the best use of limited resources in a given market.
Opportunity costs and sunk costs are two of the most common economic costs that need to be reviewed in a business. An opportunity cost is the result of choice; in short, the definition is the cost forgone when choosing one method over another. For example, making widgets instead of gears means that the company has forgotten the benefits of making gears by choosing widgets. A sunk cost is no longer recoverable. The example here would be purchasing important equipment to produce goods; once purchased, that money is no longer recoverable in economic terms.
Choice is often a driving factor in economic analysis tools that involve opportunities and sunk costs. Having to choose between two or more items, the company will not be able to go back and make changes to these decisions. Making the wrong choice can lead to little or no payoff from the end result. Spending money to go in a certain business direction can be even worse as the company spends more and more capital on a potentially non-profit enterprise.
Comparative advantage is when a firm engages in activities in which it is most efficient. The tools for economic analysis here indicate the correct use of natural resources, capital and labor skills. In short, a society – or a country for that matter – is usually unable to produce all goods in the same efficient way. Economic analysis helps determine which production is most profitable and brings the greatest benefit to the company. Uncompetitive companies don’t tend to last long.
The production possibility frontier allows a firm to determine how much of a particular good or service it can handle under certain conditions. For example, economic analysis tools can determine that a company can produce more goods than it is currently producing. The other side of this equation, however, is the ability for a market to handle this additional supply. The Production Possibilities Frontier is a detailed analysis that helps companies review these opportunities and subsequent decisions.
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