Opportunity cost is the cost of giving up one opportunity in order to take another one. The ‘next best alternative’ that must be given up comes with a cost.
For example, you may be faced making the choice: get a job straight out of university or take a gap year. If you choose to take the job, you’re giving up an amazing and educational travel experience. If you choose to take a gap year, you’re giving up a lot of money. Either way, you’re giving up one thing to achieve the other.
The widely used method of assessing the relative benefits from the varying choices and alternative decision is referred as cost and benefits analysis. It involves comparing the costs of an action or decision to the potential benefits that it could bring.
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Opportunity Cost Definition
The concept of opportunity cost was developed Friedrich von Wieser (Sturn, 2016). Wieser defined opportunity cost based upon the idea that all resources are scarce and every decision involves a trade-off (Von Wieser, 1893).
According to Wieser, the opportunity cost of a particular choice is the value of the next best alternative that must be given up in order to pursue that choice.
“Current day economists generally define opportunity Cost as the value of the resource in its next best use.”
(Shadoan & Sharp, 1989)
To make the best decision, people should think about what they have to give up (opportunity cost) for each choice.
They can then figure out which choice will be the most worthwhile (cost-effective) by comparing the benefits and costs.
The choice that gives the most overall benefit (benefits minus costs) is the one that should be chosen (Spiller, 2011).
Opportunity cost helps us understand the trade-offs that we make in our daily lives.
But opportunity cost is also something that governments should think about. Government should consider, for example, what they have to give up (opportunity cost) to make decisions that will have the greatest overall benefit for the people in their country (Shaw, 1992).
Opportunity Cost Examples
- Studying Vs. Hanging Out: Choosing to study for an exam instead of hanging out with friends comes with a cost. Studying for exams instead of handing out with friends will likely bring higher grades in an exam. The opportunity cost in this example is the time spent with friends.
- Fast Food Vs. Fancy Restaurant: Choosing to eat at a fancy restaurant instead of a fast-food restaurant comes with a cost. At the fancy restaurant, there will be quality and leisure time with friends or family The opportunity cost is the money saved at the fast-food restaurant and possibly also the time lost because the fast-food option is faster.
- Public vs. Elite Private University: Choosing to go to a public university instead of a private university comes with a cost. Going to the public university may save you money, but it might cost a level of cultural capital and prestige you gain from having attended the elite private university.
- Car vs. Public Transport: Choosing to use a car to get to work instead of taking public transportation comes with a cost. The public option may be cheaper, but the opportunity cost is the comfort while traveling in private transit.
- House in City Center vs. Suburb: Choosing to buy a house in the city instead of the suburbs comes with a cost. The house in the city will help you to access various health and educational amenities at your doorstep. The opportunity cost is the extra space and potentially lower cost of a house in the suburbs.
- Investing in Stocks vs. Savings: Choosing to invest money in the stock market instead of keeping it in a savings account comes with a cost. The investment is stocks will increase amount invested through profits shared by company and increasing share value over period of time. The opportunity cost is the potential interest earned in the savings account (Kerins et al., 2004).
- Overtime vs. spending time with family: Choosing to work overtime and make extra money instead of spending time with family comes with a cost. The opportunity cost is the time spent with family.
- New Phone vs. repairing old phone: Choosing to buy a new phone instead of repairing the old one comes with a cost. The new phone will give benefits new feature. The opportunity cost is the money saved by repairing the old phone.
- Beach vs. Mountain vacation destination: Choosing to go to a beach vacation instead of a mountain vacation comes with a cost. The opportunity cost is the different experiences and scenery at the mountain vacation.
- Watching movie at home vs. theater: Choosing to watch a movie at home instead of going to the theater comes with a cost. The opportunity cost is the cost of tickets and concessions at the theater.
- Garden in Backyard vs. other use: If you decide to plant a garden in your backyard, you are giving up the opportunity to use that space for other purposes, such as a playground or a swimming pool.
- Starting Business vs. job: If you decide to start a small business, you are giving up the opportunity to work a traditional 9-to-5 job with a steady income and benefits. However, starting your own business may help you to grow your wealth by growing business (Mickiewicz et al., 2017).
Types of Opportunity Cost
There are two types of opportunity cost: explicit and implicit.
- Explicit opportunity cost: The Explicit opportunity cost is the cost that we can directly see and measure, such as the money we spend on something.
- Implicit opportunity cost: Implicit opportunity cost is the cost of the next best alternative that we could have chosen, but did not. The implicit opportunity cost is the opportunity to do something else with that time, such as spend time with friends or relax.
Criticism, Strengths, and Weaknesses of Opportunity Cost Theory
| Strengths | Weaknesses and Criticisms |
|---|---|
| One of the strengths of opportunity cost is that it helps individuals and businesses make more informed decisions by considering the trade-offs they are making. | One criticism of opportunity cost argue that it is too narrow and does not take into account all of the potential costs and benefits of a decision. |
| It also helps people focus on the value of resources and how to use them effectively. | One of the weaknesses of opportunity cost is that it can be difficult to quantify, especially for implicit opportunity costs. |
| It can also be hard to predict the future costs and benefits of a decision, which can make it difficult to accurately calculate the opportunity cost. | |
| Opportunity cost is too subjective and depends on an individual’s values and preferences. |
Related Concepts in Economic Theory
1. Marginal analysis
Marginal analysis is a way to make decisions by comparing the costs and benefits of different options.
It involves looking at the additional or incremental benefits and costs of taking a specific action, rather than considering the overall costs and benefits (Machlup, 1946).
For example, a student might consider whether the marginal benefit of studying an extra hour for a test is worth the marginal cost of giving up an hour of leisure time.
By comparing the marginal benefit of getting a better grade on the test to the marginal cost of giving up an hour of leisure time.
Similarly, a business might use marginal analysis to decide whether to increase production of a product.
The business would consider the marginal cost of producing an additional unit of the product such as the cost of raw materials and labor and compare it to the marginal benefit of selling the additional unit.
2. Scarcity
Scarcity refers to the fact that resources are limited, while our needs and wants are unlimited. This means that we are unable to satisfy all of our desires with the resources that are available to us.
As a result, we have to make choices about how to use our resources in the most effective way (Mullainathan & Shafir, 2013).
For example, a student might have a limited amount of time, which means they have to make choices about how to use the time. They might have to decide between spending their time studying or participating in extracurricular activities.
Scarcity also affects businesses. Businesses have to make choices about how to use their resources, such as labor, raw materials, and capital, in order to produce and sell goods and services.
The scarcity also affects society as a whole. Societies have to make choices about how to allocate their resources in order to meet the needs and wants of their citizens
3. Sunk cost
Sunk cost refers to a cost that has already been incurred and cannot be recovered. It is called “sunk” because it is like a stone that has been sunk to the bottom of a lake – it cannot be retrieved. (Arkes & Blumer, 1985).
Sunk costs can also affect businesses. For example, a business might have invested a lot of money in a project that is not turning out to be profitable.
It might be tempting for the business to continue investing in the project but this would not be a good decision because the sunk costs cannot be recovered.
Many theorists believe it’s best to ignore sunk costs when making decisions and to focus on the marginal benefits and costs of different options. This can help people and businesses make better decisions that lead to more successful outcomes.
4. Time value of money
The time value of money is the idea that money is worth more in the present than it is in the future. This is because money can be invested and earn interest over time, so it is more valuable the sooner it is received (Lokken, 1986).
For example, consider a student who has the option to receive $100 today or $100 one year from now. If the student expects to earn a 5% return on their investment, they would prefer to receive the $100 today because they could invest it and earn $5 in interest over the course of the year.
The time value of money is important because it affects the decisions people make about how to use their money.
Overall, the time value of money is a fundamental concept in economics that helps people and businesses make informed decisions about how to use their resources.
By considering the time value of money, people can make choices that lead to better outcomes and greater wealth in the long term.
Conclusion
Opportunity cost refers cost of giving up the next best alternative when making a decision. It is an important concept in economics because it helps individuals and businesses understand the trade-offs they are making when they choose one option over another.
By considering the opportunity cost of different actions, people can make more informed decisions that lead to better outcomes. Understanding opportunity cost is an important part of making effective choices and achieving our goals.
References
Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost.Organizational behavior and human decision processes,35(1), 124-140.
Hoskin, R. E. (1983). Opportunity cost and behavior.Journal of Accounting Research, 78-95.
Kerins, F., Smith, J. K., & Smith, R. (2004). Opportunity cost of capital for venture capital investors and entrepreneurs.Journal of financial and quantitative analysis,39(2), 385-405.
Lokken, L. (1986). The time value of money rules.Tax L. Rev.,42, 1.
Machlup, F. (1946). Marginal analysis and empirical research.The American Economic Review,36(4), 519-554.
Mickiewicz, T., Nyakudya, F. W., Theodorakopoulos, N., & Hart, M. (2017). Resource endowment and opportunity cost effects along the stages of entrepreneurship.Small Business Economics,48(4), 953-976.
Mullainathan, S., & Shafir, E. (2013). Scarcity.Social Policy,46(2), 231-249.
Shadoan, D., & Sharp, R. (1989). The New Math for Productivity: Opportunity Cost, Revisited.Journal of Business Strategies,6(1), 75-77.
Shaw, W. D. (1992). Searching for the Opportunity Cost of an Individual’s Time.Land Economics, 107-115.
Spiller, S. A. (2011). Opportunity cost consideration.Journal of Consumer Research,38(4), 595-610.
Sturn, R. (2016). Friedrich von Wieser (1851–1926). InHandbook on the History of Economic Analysis Volume I. Edward Elgar Publishing.
Von Wieser, F. (1893).Natural value. Macmillan and Company.
Chris Drew (PhD)
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Dr. Chris Drew is the founder of the Helpful Professor. He holds a PhD in education and has published over 20 articles in scholarly journals. He is the former editor of the Journal of Learning Development in Higher Education.
