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Economics

What is an opportunity cost?

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January 04, 2016 10:12AM

The value (not just in cash!) of what you give up when you choose to do one thing rather than another.

For example, if you have two weeks vacation accrued, you can EITHER spend it skiing in the mountains OR relaxing on the beach; even if you could afford to, you cannot do both.

If you have a couple of hours, you can EITHER do your homework, OR play games. Playing games is more fun, and has an immediate payoff in terms of enjoyment, but an evening studying may make the difference between an "A" and a "C", which may mean the difference between being accepted to a particular college or being passed over. In the longer view, in terms of the difference in earning power and other opportunities later on over the course of a career, the cash value of the "opportunity cost" of a decision may be the smallest part of the equation.

Opportunity costs are something you miss out on, the "cost" you must pay in order to take the other choice or opportunity. Say you are at a fair you see two things you like 1: yummy pink cotton candy or 2: A velvet teddy bear If you choose the bear the cotton candy is your opportunity cost!

Opportunity cost is the next-best choice available to someone who chooses between several mutually exclusive choices. Examples:

  • A person who has $15 can either buy a CD or a shirt. If he buys the shirt the opportunity cost is the CD and if he buys the CD the opportunity cost is the shirt. If there are more choices than two, the opportunity cost is still only one item, never all of them.
  • A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest missed.
  • A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price (say $12,000) in the future, inheriting an opportunity cost equal to the future price of $12,000 (and not the future price minus the sale price). Note that in this case, the opportunity cost can only be determined in hindsight.
  • An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.
  • If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.

The opportunity cost is the next best alternative forgone to satisfy our want with best alternative.