Opportunity Cost: (What it is, Types & 4 Examples)
What is Opportunity Cost
If you are here, it’s probably because other explanations of opportunity cost are unnecessarily hard to read. As an economist, it is easy enough to get carried away with economic jargon rather than focusing on the audience. So that is what I will do below.
- Opportunity cost is the cost of taking one decision over another. This cost is not only financial, but also in time, effort, and utility.
- Opportunity cost can lead to optimal decision making when factors such as price, time, effort, and utility are considered.
- It’s necessary to consider two or more potential options and the benefits of each. Some may place greater value on time, whilst others on price.
Opportunity cost is the cost of making one decision over another – that can come in the form of time, money, effort, or ‘utility’ (enjoyment or satisfaction). We make these decisions every day in our lives without even thinking.
“Opportunity cost is the cost of making one decision over another. That can come in the form of time, money, effort, or ‘utility’.”
When we make a purchasing decision, we subconsciously consider several factors before making a decision. However, because we make so many decisions every day, our brain stores previous decisions we made and uses them to help speed up the decision process. Our brains simultaneously consider factors such as time, effort, and money. This then allows us to come to a decision which best optimizes how much we value each of these factors.
Example of Opportunity Cost
A consumer may purchase a croissant on the way to work. They choose this over having breakfast at home or sitting down in a restaurant for a full breakfast. A croissant is cheaper than a restaurant lunch but more expensive than breakfast at home. Yet consumers don’t sit down thinking about this decision for hours or days. These are decisions taken in minutes or seconds.
When the consumer buys a Croissant, they forego $2, or however much it costs. The opportunity cost is what could have been brought instead of a Croissant. This could be a bottle of Cola, a Pretzel, or some French Fries.
When considering opportunity cost, it is also important to consider ‘utility’, which is essentially, how much pleasure/enjoyment the individual gets. So whilst the Croissant saves time and effort, it costs more than breakfast at home and gives the consumer lower satisfaction than a full breakfast.
What is Opportunity Cost in Economics?
Opportunity cost requires trade-offs between two or more options. One is chosen and the others are foregone. In economics, it is assumed that this chosen option is the most valued and most optimal. So when a consumer purchases a Starbucks, its value is greater than the $5 paid for it. The value that the consumer receives is known as the consumer surplus, which is simply the additional value they receive from consuming the product below their willingness to pay.
Economists often refer to the opportunity cost as the next best alternative that is foregone. That may be getting a Black Coffee instead of a Latte. To the consumer, a Black Coffee may be the second-best alternative.
Just think of a time when you went into a store and they did not have the item you want in stock. You may very well choose a close substitute instead. This is the next-best product but is one that you usually forego. This is generally considered as the opportunity cost but is commonly considered using four variables.
Calculation of Opportunity Cost
Opportunity cost is an important economic concept that reflects the cost of the alternative chosen in any decision-making process. Notably, it represents the benefits an individual, investor, or business misses out on when choosing one possibility over another.
To calculate the opportunity cost, one needs to evaluate the potential returns of the next best alternative that was not chosen. The general formula used to calculate opportunity cost is as follows:
Opportunity Cost = Return of Best Foregone Option – Return of Chosen Option
However, it is essential to understand that the calculation of opportunity cost is not always this straightforward. This is because the returns of an alternative option are not always quantifiable and may involve qualitative aspects. Moreover, there can be multiple alternative options, making it more complex to identify the best foregone option.
Let’s look at a simple example. Suppose you are a student and have the option of either studying for an exam or going to a concert. If you choose to go to the concert, the opportunity cost of this decision would be the grade you could have achieved by studying.
In terms of investment, let’s say an investor has $10,000 to invest and has to choose between Stock A expected to return 8%, and Stock B expected to return 12%. If the investor chooses Stock A, the opportunity cost is the return missed out on from not investing in Stock B. This would be 12% – 8% = 4%.
It’s important to note that opportunity cost isn’t always measured in terms of monetary or material benefits. It can also be measured in terms of time, pleasure, or any other benefit that provides utility.
In conclusion, calculating opportunity cost requires a clear understanding of the options available, careful consideration of the potential outcomes of each, and an evaluation of the results. It is a critical concept that allows for better decision-making in every sphere of life, from personal choices to business decisions.
Factors of Opportunity Cost
When making decisions, there are four common factors that we consider. These are:
Perhaps one of the biggest factors is the price; although this can vary depending on income. Those will lower levels of income are more likely to place more emphasis on price as part of the opportunity cost. Eating breakfast at home, for example, is cheaper. As a result, this would be a more favorable option due to the pricing. By comparison, a billionaire is unlikely to value price as high as the three other factors.
Everyone has the same 24 hours in a day. Whether you’re Bill Gates, Warren Buffett, or your next-door neighbor. So each purchasing decision taken bears this in mind. For instance, it may be $0.50 cheaper to go to the store down the road, but is it worth the extra 10 minutes?
If you are currently working for a wage of $15 an hour; saving yourself $0.50 for 10 minutes may seem illogical. Nevertheless, it is up to the individual to value their time accordingly based on each individual scenario.
Time and effort are essentially interlinked. For instance, it may take time to go to your favorite restaurant, but also the effort of driving or walking there. So you may choose a local one that isn’t as good in order to save time and effort. In addition, you may be able to find a cheaper deal on the internet but would require you to devote time and effort.
This is essentially the enjoyment or pleasure that the consumer receives. This is perhaps one of the most important factors. Consumers all want to maximize their ‘utility’, but are limited by other factors such as time and price.
For example, consumers may want a 2 week holiday in the Caribbean, but have to consider whether they can still pay the bills. As incomes rise, the influence of utility becomes ever greater, whilst the impact of price diminishes.
Types of Opportunity Cost
Explicit Opportunity Cost
An explicit cost is a cost made as a direct payment in cash. This can include an employee’s wages, rent, or raw materials. So when looking at explicit opportunity costs, this covers what could have been used on a monetary basis. That is to say, what else could-have-been brought with that money?
For example, let us say that a business hires a new employee on a wage of $40,000 per year. When it employs that person, it foregoes $40,000 each and every year they are employed.
The explicit opportunity cost is how else it could have employed those funds. This could be updated machinery, a marketing campaign, or a bonus for its employees. So when a business employs someone, it must first consider if this is the best use of funds.
Implicit Opportunity Cost
An implicit cost is a cost that has already occurred. This covers assets that have already been purchased such as land, a factory, or machinery. As opposed to explicit costs; implicit costs refer to how a purchased asset is used after its purchase, rather than before.
Implicit opportunity costs refer to the variable options that can be pursued in order to make use of an asset. For example, a business owns a factory. It could use it to either manufacture motor vehicles, tinned fruit, or maybe even computing equipment.
When deciding how best to use the factory, it must consider the opportunity cost of not pursuing the other options. Most likely, it will choose what will make it the most profitable.
Opportunity Cost Examples
|Chosen your favourite restaurant 30 min drive away
|$10 more than eating at home
|Having to drive for 30 mins
|Maximised utility as its your favourite restaurant
|Eat at home or get a takeaway
|Grab a Starbucks Coffee on the way to work
|$5 more than getting one free at work
|5 mins waiting in line
|Having to wait in a line
|Maximised utility as its better than the one at work
|Coffee before work, coffee at work, or forego coffee altogether
|Stay at home for dinner
|Much cheaper than alternatives, potentially saving $10 over eating out
|Preparation and cooking time – may take 30-60 mins
|Having to cook and clean up
|Low level of utility, although there may be a sense of achievement for cooking a nice meal
|Eating out or grab a takeaway
|Choose the Supermarkets own-branded cereal
|Much cheaper than branded alternative, perhaps saving $2
|No time savings or cost
|No more effort required
|Low level of utility as the own-brand may not taste as good
|Branded cereal or other breakfast substitute
Opportunity costs refer to the trade-offs between two or more options/decisions. It is assumed that the chosen option is the most valued. So when you buy a coffee from Starbucks in the morning; this is of greater value than the $5 you paid.
For example, we may purchase a Croissant on the way to work. We choose this over having breakfast at home or sitting down in a restaurant for a full breakfast. A croissant is cheaper than a restaurant lunch but more expensive than breakfast at home. We don’t sit down thinking about this decision for hours or days. These are decisions we take in minutes or seconds.
Opportunity cost is an important concept in decision-making because it helps you understand the true cost of a decision. By considering the opportunity cost, you can make a more informed decision that takes into account all of the alternatives.
Opportunity cost is closely related to the concept of trade-offs. When you make a decision, you are often choosing between different options, each of which has its own benefits and costs. The opportunity cost is the cost of the option that you did not choose, and it represents the trade-off that you made.
In economics, opportunity cost is the economic cost of an action taken over another alternative. In other words, it’s the price paid to take one decision over another. For example, you may have $2 to spend at the shop. The decision may come down to deciding between a bag of chips or a chocolate bar. If you choose the bag of chips, the opportunity cost is the benefit you would receive from the chocolate bar.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.