An opportunity cost (OC) is a fundamental idea in microeconomics that you should understand. It is the advantage you forego when you decide to take a different course of action. Every decision you make has some sort of opportunity cost, whether it’s choosing an investment, a career, or something as simple as where to eat dinner. There are many ways we can use it in our daily lives. There are also many ways to incorporate opportunity cost theories into daily life. Continue reading as you will find out what an opportunity cost is, its formula, and its different types, with an example.
What is Opportunity Cost?
Opportunity costs are the potential advantages that a person, investor, or company forgoes when deciding between two options.
By definition, opportunity costs are invisible, making it simple to ignore them.
Making better decisions requires an understanding of the potential opportunities lost when a company or person selects one investment over another.
How Does Opportunity Cost Work?
When you select an option or make a choice, you’re actually making several choices. Besides choosing what to do, you are also making several decisions about what not to do.
When you choose to eat lunch at McDonald’s, you are also forgoing Burger King, Wendy’s, or the fanciest French restaurant in town. What you lose are the delicious burgers, chicken nuggets, or escargot from the restaurants you avoided.
In a more serious example, suppose you can choose to work an additional shift or spend the day at home with your family. If you work an eight-hour shift for $15 an hour, they will pay you $120 for your time. Say you decide to do as you had intended and stay at home. The opportunity cost means that you no longer make that $120. But suppose you accept the shift. You’ll now lose out on family time, which represents an OC.
Opportunity Cost Formula and Calculation
Although opportunity cost cannot be calculated, one way to estimate it is to project the potential future value that you chose not to receive and contrast it with the value of the choice you made.
The formula for Opportunity Cost = Return on the Most Profitable Investment -Return on the Investment Selected to Pursue
Fundamentally speaking, OC is a concept that both investors and economists find interesting.
For instance, what would have happened if Walt Disney had never started making animated movies? You may not know his name, or he may have accomplished something equally successful.
The key is that there is something to gain and lose in each direction, which is the proverbial fork in the road with dollar signs on each path. By calculating the losses for each choice, you can make an informed choice.
You can use the formula above to calculate an opportunity cost right away.
Opportunity Cost Example
Think about the decision between selling stock shares now or holding onto them to sell later as an example of opportunity cost.
While an investor can protect any immediate gains they may have by selling right away, they lose any potential future gains from the investment.
The decision between going to work and skipping work is another illustration of OC. What do you give up by selecting one over the other?
OC can also apply to choices made in daily life, not just financial or investment decisions.
Types of opportunity cost
The two types of opportunity costs that economists consider are explicit and implicit.
Explicit opportunity cost
According to Dr. Bob Castaneda, director of the College of Management and Technology at Walden University, “Explicit costs are those that are incurred when taking a specific course of action.”
Wages, supplies, stock purchases, rent, utilities, and other tangible costs could all be explicit opportunity costs associated with a decision.
The explicit costs include any monetary sum needed to proceed with a decision.
Implicit opportunity cost
However, “implicit costs may or may not have been incurred by foregoing a specific action,” according to Castaneda.
Implicit costs are indirect and sometimes challenging to determine.
They stand in for any potential earnings or other advantages that would have arisen from a different decision.
I believe you now have a better grasp of the two types of opportunity costs.
Importance of Opportunity Cost
Opportunity Cost is a crucial concept in the business and financial worlds.
It describes the reasons behind the financial decisions made in relation to the other available options.
We’ll examine the significance of OC for production and investment.
Production
When deciding what to produce, opportunity cost provides important direction and guidance.
It sheds light on the following issues:
- A manufacturer can make a production decision based on the opportunity cost. He can compare choosing a production activity to the alternative of doing no production at all to determine the economic benefit of doing so. The same amount of money, time, and resources could be used to invest in another venture. He can then choose whether or not to produce, depending on which option provides him with the highest returns.
- A company can choose what to produce thanks to this idea. Losing the chance to offer another product is the opportunity cost of building a product. Having considered the advantages of producing product B, a producer may decide to go with product A.
- A manufacturer may also consider the implicit opportunity cost of working somewhere else but not receiving a salary. It will provide a realistic assessment of the value of his time and resources. To continue with his business and not give up, returns from manufacturing and business should be greater than his estimated implicit cost.
Investing
Making investments and other related decisions requires an understanding of opportunity cost.
#1. Every company or person should consider the opportunity cost of buying a home or piece of land rather than continuing to pay rent.
A person must determine whether purchasing land or office space will benefit him more financially than continuing to pay rent for the same.
He can contrast the interest income he could receive with the cash he will use to purchase the home or business.
If it is significantly higher than the rent he is currently paying, he may decide against purchasing the land or home.
#2. The missed opportunity of investing in a different option is the opportunity cost of investing in anything.
Losing the opportunity to invest in stock A or another asset, such as gold, is an example of the opportunity cost of buying stock B.
An investor will consider all of his options and make the best investment decision.
However, additional factors will be considered, such as his willingness to take a risk in order to earn greater returns, the maturity period, etc.
Opportunity Cost Theory
Many theories about the macro and micro aspects of global trade have been developed by Haberler, Ohlin, Samuelson, Leontief, Hecksher, and many others.
Despite being the cornerstone of global trade, Ricardo’s comparative cost theory principle has come under fire from many economists.
Since labor is the only factor of production and is homogeneous, Ricardo’s theory of comparative costs is based on the labor theory of value.
These assumptions have been discovered to be unreal.
Gottfried Haberler’s theory of opportunity cost, which explains the theory’s doctrine in terms of “the substitution curve,” addresses these issues, or, as Samuelson put it, the “production possibility curve” or “transformation curve.”
It was referred to by Lerner as the “production frontier” or “production indifference curve.”
It is determined that Haberler’s theory is more conceivable.
The Theory of Opportunity cost
When deciding between two or more commodities, the opportunity cost is the cost of the loss.
To further explain
According to the opportunity cost theory, the opportunity cost of commodity X, if a nation can produce either commodity X or Y, is the quantity of commodity Y that must be sacrificed in order to get one additional unit of commodity X.
In terms of their opportunity costs, the exchange rate between the two commodities is stated.
The OC of the extra quantity of the specified commodity is shown by the drop in the quantity of the second good.
What Are the Types of Opportunity Costs We Have?
The two types of opportunity costs we have are explicit and implicit.
What Is the Opportunity Cost Formula?
The opportunity cost formula is Opportunity Cost = Return on the Most Profitable Investment -Return on the Investment Selected to Pursue
To Wrap Up
“Opportunity cost” is a fairly fundamental microeconomics principle. It explains what you lose when you make a choice by thinking about what you might have gained if you had chosen differently.
The money you could have made if you had accepted a different job offer, for example, is the opportunity cost of accepting a job offer. While implicit opportunity costs cannot be measured economically, explicit opportunity costs can.
When investing, whether in stocks, bonds, or something else, consider the opportunity cost of your decisions. Don’t let your indecision, however, cause you to become helpless. After all, the greatest OC comes from not investing at all.
