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Opportunity Cost

Updated on April 4, 2024
Article byAswathi Jayachandran
Edited byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Opportunity Cost?

Opportunity cost is a term that describes the potential benefit one foregoes while choosing an alternative over the next-best choice. They can be thought of as a trade-off. When one choice is chosen over another, trade-offs occur in the decision-making process and represent the cost involved.

What Opportunity Cost Means?

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Source: Opportunity Cost (wallstreetmojo.com)

It is the value a company loses when choosing between two or more alternatives. Therefore, a business or individual must be aware of the opportunities they lose whenever they pick one investment or decision over another. This requires careful weighing of the alternatives and deciding what’s best.

Key Takeaways

  • Opportunity cost is the potential gains forfeited when a person, company, or investor selects one alternative over another.
  • Although it is an abstract and quantifiable term, this cost cannot be quantified, like the price of a commodity or service sold or the cost of a good or service produced.
  • There are two types of Opportunity Cost – Explicit costs and implicit costs.
  • The equation is = FO (return on the best-forgone choice) – CO (return on the chosen option).
  • They are beneficial tools while evaluating the viability of investment or trading decisions.

Opportunity Cost Theory Explained

Opportunity cost is the potential gains forfeited when a person, company, or investor selects one alternative over another. One can very easily overlook the costs since they are not visible. The core element of conventional economics is that demands are unlimited. The more the number of demands, the better it is for the economy‘s growth. This is the foundation of this concept. Customers who purchase a certain good or service miss out on the chance to benefit from something else’s utility.

In simple terms, an expense happens when an entity loses a chance or opportunity. Another related concept in economics is the increasing opportunity costs. The law of increasing opportunity cost states that if there is an increase in the production of one product, the opportunity cost to produce the additional good will also increase.

Businesses may need to analyze the Opportunity Cost of capital, investments, etc. Similarly, investors look into the cost of investing in one stock over the other. Opportunity cost, from the standpoint of the investor, implies that the choices taken about investments will result in future gains or losses that are immediate.

At its foundation, economics is the study of how people make choices in the actual world regarding the distribution of limited resources. If there were no resources, it would eliminate the need to forgo any preferred activity, allowing for completing all tasks. Therefore, every action has an opportunity cost. Thus, it’s critical to make an effort to comprehend the full scope of these expenses before making decisions.

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Video Explanation of Opportunity Cost Formula

Assumptions

Although this is an abstract and quantifiable term, it cannot be quantified, like the price of a commodity or service sold or the cost of a good or service produced. Three key assumptions form the foundation of opportunity cost for the consumer:

  1. Wants are unlimited.
  2. Wants and necessities are equivalent.
  3. The consumer constantly pursues maximum personal net advantage.

The opportunity cost for the producer is based on the ideas that (a) the choice foregone is feasible and (b), like the consumer, the producer continuously pursues maximum personal advantage.

The equation is as follows:

Opportunity Cost = FO (return on the best-forgone choice) – CO (return on the chosen option).

The difference between the projected returns from each choice serves as the basis for calculating opportunity cost.

Types

There are two types of opportunity costs:

#1 – Explicit Costs

Explicit costs are direct costs which associate with an action. They are easily identifiable as out-of-pocket expenses. For example, payments made to employees, land and infrastructure costs, cost of capital, operations, maintenance costs such as wages and rent, etc., belong to this category.

#2 – Implicit Costs

Implicit costs are implied costs that one cannot easily identify. They are the costs of firms utilizing resources they could have used for other purposes. They correspond to intangibles and are not visible. One cannot, therefore, report them easily. This can include a small business owner starting without a salary to increase the company’s profitability.

Example

Dan has two options to invest in his monthly paycheck. Company ABC gives a rate of interest of 10%, and company XYZ gives a rate of interest of 12%. However, Dan aims to earn some passive income. Even though it shows only 10% interest, ABC has a track record of continuously providing dividends. In contrast, XYZ has long gaps between its dividends. Therefore, Dan inclines more towards ABC, as he sees it as the one that can provide a potential continuous source of income. In this case, the 2% rate of interest he forgoes is his Opportunity Cost. (12%-10%).

Importance

The importance of opportunity costs can be summarized as the following key points:

  • When making decisions like forgoing short-term gains in favor of a longer-term investment, these costs help weigh each option’s benefits and drawbacks.
  • These expenses help evaluate the viability of a specific business opportunity. It may also assist individuals in deciding whether a particular course of action would benefit them in the long run.
  • Making a sound decision from various options may become easier on knowing the cost of forgoing and can make the process simpler.
  • It helps determine the benefits and disadvantages of the present course of action or decision.
  • Finally, It is beneficial while analyzing long-term objectives.

Limitations

Some of the limitations of opportunity costs are:

  • Calculating these costs cannot predict future results accurately.
  • Quantitative comparisons between the two available options can sometimes be challenging.
  • These costs differ from individual to individual and circumstance to circumstance.

Opportunity Cost vs Trade Off vs Sunk Cost

Sunk costs are also referred to as historical costs, which have been incurred already and cannot be recovered in the books. As sunk costs have already been incurred, they tend to remain unchanged and should not influence future actions or decisions regarding benefits and costs. Opportunity costs are those that are forgone for the next best alternative. On the other hand, when individuals or a group of individuals make decisions to endure sacrificing one thing to obtain more of another, this is a trade-off.

Frequently Asked Questions (FAQs)

1. What are the marginal opportunity costs?

The marginal opportunity cost is the number of units of one product that must be sacrificed to create an additional unit of another good. The Marginal Rate of Transformation is another name for it (MRT).

2. How to determine opportunity cost?

Calculating this cost is easy and can be done through the equation
Opportunity Cost = Return on the Most Viable choice- Return on actual choice.

3. Why is opportunity cost important?

These costs are a significant factor in decision-making in business. For an investor, it entails profits; for an individual, it entails smart choices; for a producer, it entails purchase and manufacturing decisions.

4. Why do opportunity costs exist?

There are limited resources and unlimited wants. Therefore, it is necessary to forego something desirable to attain one outcome. Therefore, everything in the economic sense has a cost, essentially known as “opportunity cost,” as it is a missed opportunity.

This article has been a guide to what is Opportunity Cost & its definition. We explain its types, example, importance, limitations, and comparison with trade-off and sunk cost. You may also find some useful articles here –

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