Opportunity Cost
Here is an important term that you will often hear used in business, economics, and the news.
Everyone knows what the “cost” of something is. If I told you that going to a certain university as a full-time student for 4 years cost $10,000 per year, you would know that the total cost of the 4-year program is $40,000.
The opportunity cost is different. The opportunity cost also includes what else you are “giving up” by making that decision. The opportunity cost can be applied when you are making a decision between doing two or more things.
In our simple example, let’s say that you are considering doing one of two things:
a:)go to school for 4 years or
b:)not go to school and working instead.
Let’s assume that if you didn’t go to school you would be able to earn $30 000 per year during that time. That would be $120,000 that you wouldn’t have if you had instead chose to go to school. In this case we say that the opportunity cost of going to school is the $40,000 of tuition + the $120,000 that you would have earned if you chose to work instead. Therefore the opportunity cost of going to school would be $160,000. That sounds quite expensive. We could even complicate this further by including the money that you would have earned on investments during the time you were working.
Basically, the point of the opportunity cost is to help you evaluate the “real” costs of choosing one option instead of another.
It doesn’t only have to be about money either. For example, imagine that you have a girlfriend (or boyfriend) and you are deciding whether or not you will move to another country without her. You have decided that if you do move, you will break-up. That means that your girlfriend is an opportunity cost of moving because you will be losing her if you go away.
I hope this explanation was clear and you will be able to use this term confidently. Let me know if you have any questions.
Andy
March 23rd, 2008 at 3:06 am
Here is a good explanation you gave, Andy, but I’d like to give my own. The opportunity cost of any resource (product, service etc.) actually equals the cost (the value) of it in its best usage. It’s very significant in distinguishing accounting and economic profit. The last one is significant for making managerial decisions about where to invest your money, your efforts. It’s also logically close to methods of project analysis, especially to the method, called DCF (discounted cash flows). It takes into account “invisible” benefits from the alternative ways of investing your money, resources. Those alternative benefits turn to costs for your business, because you refuse them for benefit of the only one you’ve chosen. Why did I add “in its best usage”? Well, let’s take again your example with going to school. You assumed that instead of going to school you would be able to earn $30000. I’d like to add to this case, that you would be able to earn $30000, working as a bartender in “Praha”, $25000, working as an accountant assistant and $20000, being a part-time worker in “McDonalds”. In this new situation the opportunity cost remains $30000, because you get the highest price for your labor resource and, thus, the position of the bartender is the best usage for your workforce.
March 25th, 2008 at 7:59 am
this is a very good question. A couple of days ago , i think about it carefully. Sometimes we must put our eyes in the future and what great chances we will meet after school , we don not know now. maybe good ,maybe bad.
April 17th, 2008 at 1:45 am
This is cool. whe use this kind of therms in finacil life. the cost oportunity is always relative. Because we, i dont know if is used this expression in english but, we have to open hand of doing something we want to do another thing that is important for us too!
Nice subject Andrew!!
April 17th, 2008 at 1:46 am
This is cool. whe use this kind of therms in finacil life. the Opportunity Cost is always relative. Because we, i dont know if is used this expression in english but, we have to open hand of doing something we want to do another thing that is important for us too!
Nice subject Andrew!!
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