Opportunity cost

For more information on opportunity cost, visit Britannica.com.

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6%-2%).

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1. The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.

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In general: highest price or rate of return an alternative course of action would provide.

Corporate finance: concept widely used in business planning; for example, in evaluating a Capital Investment project, a company must measure the projected return against the return it would earn on the highest yielding alternative investment involving similar risk. See also Cost of Capital.

Securities investments: cost of forgoing a safe return on an investment in hopes of making a larger profit. For instance, an investor might buy a stock that shows great promise but yields only 2%, even though a higher safe return is available in a money market fund yielding 5%. The 3% yield difference is called the opportunity cost.

Value given up as a result of not taking certain action. The revenue foregone as a result of being unable to supply enough product to meet demand is an opportunity cost. When choosing between two alternative courses of action, such as choosing which new product to take to market or which investment to make, the earnings that would have been generated by the investment not selected are an opportunity cost.

A term used in economics; when taking a particular action, the loss of the value of the next-best action.
Example: Jim had to choose between two investment properties because he did not have the resources to buy both. Each cost the same; the better one offered a 10% return on investment, the other only 9%. Jim's opportunity cost of the better one (which he bought) was measured as the 9% return of the one he did not buy and, therefore, had to do without.

One of the lamentable facts of life is that nobody can have everything that he or she wants. This is due, in part, to scarce resources. Whether a teenager with a part-time job or a wealthy business-person, no single person owns all of the money in the world. Furthermore, there are only twenty-four hours in a day, and seven days in a week. Time and money are only two of the many resources that are scarce in day-to-day living.

Unfortunately, because of these limits, individuals have to make choices in using scarce resources. One can use his or her time to work, play, sleep, or pursue other options. Or, one can select some combination of possible activities. People can't spend twenty-four hours a day working, twenty-four hours a day playing, and twenty-four hours a day sleeping. People can choose to spend their salary on a nice house, an expensive vacation, or on a yacht, but they probably can't afford all three. They must make choices with their limited resources of money.

In making choices for using limited resources, it is reasonable to evaluate the costs and benefits of all possible options. For instance, suppose one has been trying to decide how to spend the next few years of one's life. He or she has narrowed the options down to two: (1) working at a full-time job, or (2) becoming a full-time student. Going to school will cost approximately $12,000 per year in tuition, books, and room and board at the local state university for the next four years. In addition, he or she will forego the salary of a full-time job, which is $24,000 per year. This makes the total cost of going to school $36,000 per year. In return he or she gets the pleasure, social interaction, and personal fulfillment associated with gaining an education, as well as the expectation of an increase in salary through the remainder of his or her work life.

The question that must be answer is, "do the benefits of education outweigh the costs?" If they do, school should be selected. If the costs are greater than the benefits, the full-time job should be kept.

An "opportunity cost" is the value of the next-best alternative. That is, it is the value of the option that wasn't selected. In the example, if the person had chosen to keep your job, then the opportunity cost is the benefit of going to school, including the intangible benefits of pleasure, social interaction, and personal fulfillment as well as the tangible benefit of an increased future salary for their remaining working life. If the person had chosen to go to school, then the opportunity cost is the $24,000 per year that would have been earned at the full-time job.

One way of visualizing this concept is through the use of a production possibilities curve—a graph that relates the tradeoff between two possible choices, or some combination of the possibilities. Consider a very simple possible economy for a country. This country can produce two goods: guns (i.e., defense) or butter (i.e., consumer goods). If this country has historically used all of its resources to produce guns then it may be willing to consider allocating some of its resources to the production of butter. Initially, the resources that are least effective in producing guns (e.g., farmland) will be reallocated to the production of butter. Thus, the country doesn't forfeit many guns to produce a relatively large amount of butter. However, as the country reallocates more resources to the production of butter they are decreasingly productive. At the extreme, when the country gives up the last of its production of guns, the resource is very good for producing guns and not very useful in the production of butter (e.g., a high-tech armaments production facility). Figure 1 demonstrates this situation graphically in showing an example of the production possibilities curve.

In Figure 1, everything on the curved line or in the gray area is a possible production combination of guns and butter in the simple economy. Any combination on the line uses all of the available resources, while any combination in the gray area is considered inefficient since it does not use all of the available resources. Any combination in the white area is impossible to achieve, given the country's resource limitations.

The idea that the country will initially reallocate its least productive resource to the production of the other good is known as the law of increasing opportunity cost. Thus, if the production of the initial ton of butter costs five hundred guns, then the next ton of butter, which uses resources that are better at producing guns, will cost more guns. The next ton of butter will cost still more guns, and so on. This is represented in Figure 1 by the changing slope of the production possibilities curve.

Summary

Because resources are limited, choices must be made. When evaluating choices in this decision making process, one attempts to select the best option; that is, one selects the option that offers the most benefit for the costs incurred, and which are possible given any constraints. This is true for individuals, businesses, or countries, though the decisions that each entity makes are vastly different. The second best option is called the opportunity cost and is what is given up when decisions are made.

[Article by: DENISE WOODBERRY]

A term used in neoclassical economics to express cost in terms of sacrificing the alternatives. For example, if land is kept as green belt, the sacrifice will be in terms of the increased value of that land if it were available for development. This is an important idea for geographers who hope to explain resource allocation between different activities, and the idea is also significant in the theory of comparative advantage.

The cost of taking part in one activity in terms of the lost opportunities, which could have been pursued using the same resources of time and money. Opportunity cost is mainly an economic concept, but it is also applied to sport where success commonly depends on the athlete devoting his or her youth to the pursuit of success, often at the expense of career opportunities.

The amount of money that is alienated by choosing to use it for one project rather than another, i.e. the opportunity to make a profit by investing in another project is lost.

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