Introduction
Opportunity cost is the value of the next best option you give up to choose a particular decision. It’s an economic concept that considers the benefits and costs of various options when resources are limited. Individuals and businesses must weigh the benefits of each option against its opportunity cost. For example, holding money as an asset incurs an opportunity cost in potential returns. Sunk costs shouldn’t factor in decisions. Opportunity cost plays a critical role in evaluating investment options. But did you know that opportunity cost holds a secret that could change the way you make decisions? Keep reading to discover the hidden power of this economic concept and how it can help you make smarter choices.
Table of Contents
- Introduction
- Opportunity Cost definition
- The importance of Opportunity Cost
- Opportunity cost of a decision
- Tradeoffs and Sunk Costs
- Capital budgeting and opportunity cost
- How opportunity cost and scarcity affect entrepreneurs
- How is the opportunity cost calculated: the formula
- Opportunity cost calculator: table and chart
- Conclusions
- Bibliography
Opportunity cost definition
Opportunity cost is the value of the next best alternative that must be foregone in order to pursue a certain action or decision. It is the cost of choosing one option over another, and the potential benefits that could have been gained from the foregone option. In other words, opportunity cost is the value of the best alternative that was not chosen (Mankiw, 2014).
Indeed, opportunity cost is a key consideration in determining the best possible course of action in decision making. It requires evaluating the potential benefits of different options and weighing them against the cost of forgoing the next best alternative. In other words, opportunity cost is an economic concept that is used to make decisions about the best use of scarce resources.
The term opportunity cost was first used by the Austrian economist Friedrich von Wieser in his 1914 book "Social Economics." However, the concept had been discussed earlier by other economists, including David Ricardo, who wrote about the concept of "comparative advantage" in the early 19th century.
Opportunity cost itself is not inherently good or bad as it is simply the value of the next best alternative that is forgone when making a decision. It is a concept used to weigh the benefits and costs of different choices, and it is up to the individual or organization to determine whether the opportunity cost is worth the potential benefits of a particular decision.
The importance of Opportunity Cost
This particular kind of cost absolutely crucial because it is directly related to almost every decision making process, both in business, in government and in personal uses. Indeed, opportunity cost cannot be completely avoided, as it is an inherent part of any decision-making process. Whenever a choice is made, the potential benefit that could have been derived from the other alternative is lost. However, it is possible to minimize opportunity cost by carefully analyzing the available options and making informed decisions based on the goals and priorities of the individual or organization. Additionally, regularly reviewing and updating decisions can help to mitigate any negative impact of opportunity cost over time.
This inevitability is a result of scarcity, as every choice made by an individual or business involves sacrificing one alternative in favor of another. Scarcity creates the need for individuals and businesses to make choices, which are driven by opportunity cost.
Think about the opportunity cost for holding money as an asset, hence to the potential return that could have been earned if the money had been invested or used in some other way instead of being held as cash or a low-yield savings account.
For example, if an individual decides to keep $50,000 in a savings account that earns, after tax and fees, 1% interest per year instead of investing it in a 60/40 portfolio that has a potential return of 6% per year, the opportunity cost of holding that money as cash is 5%. In other words, the individual is giving up the potential to earn an additional 5% return on their investment by choosing to hold the money as cash.
However, it isn’t that simple: the risk profile of each option varies over time.
Moreover, the (opportunity) cost will rise as the time goes by: since inflation can erode the purchasing power of money over time, by holding cash, individuals and businesses are at risk of losing purchasing power over time.
Opportunity cost of a decision
When making a decision, individuals and businesses must weigh the benefits of each option against the opportunity cost of choosing that option. It is basically the cost of the opportunity that is lost.
In case of three options?
To illustrate how opportunity cost works, let’s consider the example of a student who has to choose between studying for an exam, working part-time, or going out with friends.
If the student chooses to study for the exam, the opportunity cost would be the time and money that could have been earned from working or the enjoyment of spending time with friends. If the student chooses to work instead, the opportunity cost would be the time and effort that could have been put into studying or spending time with friends. Similarly, if the student decides to go out with friends, the opportunity cost would be the time and money that could have been earned from working or the benefits of studying.
Therefore, opportunity cost plays a crucial role in decision-making, especially when resources are limited. It helps individuals and businesses to assess the potential benefits and drawbacks of different choices and to make informed decisions based on their goals and priorities (Gwartney et al., 2016).
Tradeoffs and Sunk Costs
Every decision involves tradeoffs and an opportunity cost. When individuals or businesses make tradeoffs, they must consider the opportunity cost of each alternative.
Nevertheless, opportunity costs do not involve sunk costs.
Sunk cost refers to costs that have already been incurred and cannot be recovered. Sunk costs should not be considered when making decisions, as they are irrelevant to the current decision. However, people often have a hard time ignoring sunk costs, which can lead them to make poor decisions.
Capital budgeting and opportunity cost
Opportunity cost plays a crucial role in capital budgeting decisions as it helps in evaluating the potential benefits of various investment options. Capital budgeting involves making decisions regarding investments in long-term assets such as buildings, machinery, and equipment. In this context, opportunity cost refers to the cost of the next best alternative foregone when choosing one investment option over another. Thus, in capital budgeting, opportunity cost is the return that could have been earned from the next best investment opportunity that was foregone in favor of the chosen investment (Peterson, 1998).
If a company has two investment options, A and B, and it chooses option A, the opportunity cost is the return that could have been earned from option B.
If the potential return from option B is higher than that of option A, then the company may have missed out on a better investment opportunity.
Moreover, opportunity cost can also help in determining the minimum acceptable rate of return for investment projects. The minimum acceptable rate of return is the rate that an investment must earn to compensate for the opportunity cost of not investing in the next best alternative. For example, if the minimum acceptable rate of return is 10%, it means that an investment must earn at least 10% to compensate for the opportunity cost of not investing in the next best alternative that could have earned a 10% return (Peterson, 1998).
When it comes to investing, according to Garg and Narayan (2014), the opportunity cost of funds is an important concept in financial decision-making, as it helps investors to evaluate the expected returns of different investment options and choose the one that provides the highest return for the level of risk taken. In addition, it can also help investors to assess the cost of capital and determine the minimum return that an investment opportunity must provide to be considered as viable.
Similarly, Ouyang and Wang (2018) argue that the opportunity cost of funds is a crucial consideration for investors who want to maximize their Returns On Investment (ROIs). They emphasize that by comparing the expected ROI opportunity with the potential return of alternative investment opportunities, investors can make informed investment decisions and increase their chances of achieving their investment goals.
How opportunity cost and scarcity affect entrepreneurs
Opportunity cost and scarcity are important concepts that have a significant impact on entrepreneurs. Entrepreneurs must make strategic decisions in order to maximize their profits, and opportunity cost and scarcity are important considerations in this process.
In this sense, they must consider the opportunity cost of each decision they make, in order to ensure that they are making the best use of their resources (i.e. the optimal allocation of resources). For example, if an entrepreneur decides to invest in a new product line, they must consider the opportunity cost of this investment in terms of the potential profits they may be giving up by not investing in other areas of the business.
The impact of opportunity cost and scarcity on entrepreneurs can be significant. These factors can make it difficult to make strategic decisions, as entrepreneurs must weigh the potential benefits of different options against the costs of pursuing those options.
In addition, entrepreneurs often have to consider the opportunity cost of not pursuing other business opportunities, as they may not have the resources to pursue every idea. However, successful entrepreneurs are those who are able to navigate these challenges and make strategic decisions that enable them to achieve their goals despite these limitations.
How is the opportunity cost calculated: the formula
Opportunity cost is calculated by determining the value of the next best alternative that is foregone as a result of choosing one option over another. The formula for calculating opportunity cost can be expressed as:
Opportunity Cost = Value of the Best Alternative Foregone - Value of Chosen Option
To illustrate this formula, let’s say you have a choice between going to work for a company that pays you $50,000 per year or starting your own business that has the potential to earn $70,000 per year. If you choose to work for the company, your opportunity cost would be:
- Opportunity Cost = $70,000 – $50,000
- Opportunity Cost = $20,000
In this example, the opportunity cost of working for the company is $20,000, which is the amount of money you could have earned if you had chosen to start your own business instead.
It’s important to note that opportunity cost is not always expressed in monetary terms, and can also be measured in terms of time, effort, and other resources that are foregone as a result of a particular decision.
Can opportunity cost be time?
Did you know that the biggest secret about opportunity cost is that it’s not just about money or physical resources? Time is also a resource that inherently has an opportunity cost: every moment you spend doing one thing is a moment you can’t spend doing something else.
Opportunity cost can actually be time. In fact, time is often considered one of the most important and valuable resources, and the opportunity cost of using it in one way is the value of what could have been accomplished if it had been used in another way. For example, if you choose to spend time watching a movie, the opportunity cost is the value of what you could have done instead with that time, such as studying or working.
In business and economics, the opportunity cost of time is often factored into decisions about investments, production, and resource allocation. For instance, a business may consider the opportunity cost of the time it takes to develop a new product versus the potential profits that could be generated by launching it quickly. Similarly, an individual may consider the opportunity cost of the time it takes to commute to work versus the benefits of living further away from their workplace.
The relationship between Opportunity Cost and PPF
The production possibility frontier (PPF) is a graph that shows the maximum combination of goods or services that can be produced using limited resources and technology. It represents the different trade-offs that must be made when allocating resources to produce different goods or services.
Opportunity cost is closely related to the PPF because it reflects the cost of producing one good or service in terms of the foregone production of another good or service. As we move along the PPF to produce more of one good or service, we must give up some production of another good or service. In other words, the PPF shows us the limits of production, and the slope of the PPF represents the opportunity cost of producing one good or service in terms of the other.
Translating into practice these trade-offs involves analyzing marketing opportunities, margins per product/service, tax implications and discounting future cash flows.
Calculation cases
when opportunity cost is equal to zero
Opportunity cost can be zero in certain circumstances. This occurs when the cost of one alternative is the same as the cost of the other alternative. In such a case, choosing one alternative over the other will not result in any additional cost or benefit, and the opportunity cost of choosing one alternative over the other will be =0. However, this is a rare occurrence as in most situations there is some trade-off between alternatives, and choosing one alternative over the other will result in a certain degree of opportunity cost.
opportunity cost <0
Opportunity cost can be negative when the return on the alternative option is greater than the return on the chosen option. In other words, when the option that was not chosen has a higher potential return or benefit than the option that was chosen, the opportunity cost is negative. This situation can occur when a decision is made based on incomplete information, inaccurate assumptions, or poor judgment. However, it is important to note that the concept of opportunity cost typically focuses on the comparison of two or more alternatives that are mutually exclusive and cannot be pursued simultaneously, so a negative opportunity cost is relatively rare in practice.
When increases?
We’ve just seen the role of time as a driver of opportunity cost growth.
In general, opportunity cost increases when the alternative options become more valuable or attractive. This means that the cost of choosing one option over another increases as the potential benefits of the foregone option increase. For example, if an individual has the option to invest in either a low-risk bond or a higher-risk stock, and the stock experiences significant growth, the opportunity cost of choosing the low-risk bond over the stock increases because the potential benefits of the stock have increased. Similarly, if an entrepreneur has the option to invest in two potential projects and one of them suddenly becomes more profitable, the opportunity cost of choosing the less profitable project increases as the potential benefits of the more profitable project increase.
Opportunity cost calculator: table and chart
Calculating Opportunity Cost of Two Products
| Outputs | Product Alfa | Product Beta | Opportunity Cost |
|---|---|---|---|
| A | 0 | ||
| B | 1 | ||
| C | 2 | ||
| D | 3 | ||
| E | 4 | ||
| F | 0 | 5 |
Production Possibility Frontier (PPF): Simplified Version
Opportunity Cost Example: Going to College
The opportunity cost when deciding to go to college is the potential income that could be earned if one entered the workforce directly after high school versus the income that could be earned with a college degree.
For instance, let’s say that a high school graduate could earn $30,000 per year if they entered the workforce immediately after graduating. However, if they choose to go to college, they may incur tuition costs and lose out on the potential income for the years spent in school. Let’s say that their tuition costs and other expenses totaled $100,000 for four years of college.
After graduation, they may be able to earn a salary of $50,000 per year with their degree. In this case, the opportunity cost of going to college would be the $30,000 per year they could have earned had they entered the workforce immediately after high school. Over four years, this adds up to a total opportunity cost of $120,000.
However, if the graduate works for 30 years after graduation, the college degree could lead to an additional $20,000 in income per year compared to not having a degree, resulting in a cumulative earning advantage of $600,000. Therefore, in this case, the opportunity cost of going to college may be outweighed by the long-term benefits of having a degree.
Conclusions
In conclusion, this article has explored the concept of opportunity cost and its ever-presence importance in decision making, both in personal and business contexts. The research has demonstrated that opportunity cost is a crucial factor that must be considered when evaluating different options, as it provides a framework for weighing the benefits and drawbacks of each choice. Moreover, the study has highlighted the role of opportunity cost in capital budgeting decisions, where it is used to evaluate the potential benefits of various investment options. In addition, the research has shown the importance of regularly reviewing and updating decisions to mitigate any negative impact of opportunity cost over time. Ultimately, the findings of this study suggest that a better understanding of opportunity cost can lead to more informed and effective decision making, which can ultimately contribute to the achievement of personal and business goals.
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