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While the term opportunity cost has its roots in economics, it's also a very important concept in the investment world. It's a model that can be applied to our everyday decisions, as we're faced with making a choice between the many options we encounter each day.
In this publication, we're going to explain the concept of opportunity cost. As part of that explanation, we're going to provide a definition of the term. Next, we'll explain how the term is related to choice and scarcity. Finally, we'll provide several examples that help demonstrate the concept of opportunity cost and how it applies to economics, investing, as well as the business world.
Understanding Opportunity Costs
When faced with a decision, the opportunity cost is the value assigned to the next best choice. The value or opportunity not chosen by the decision-maker could take many forms, including assets (such as a car or home), resources (such as land) or even benefits. When companies make decisions to purchase one asset over another, they're passing up the opportunity cost offered by the asset not chosen.
Scarcity of Resources and Choices
Individually, we're faced with decisions between two or more choices all the time. For example, we might tell a friend we cannot make their party Saturday afternoon because we need to attend our daughter's piano recital. Realistically, we're telling that coworker we're choosing to go to the recital, and passing on the opportunity to attend their party.
We need to make this choice because we cannot be in two places at the same time. Our time is limited and scarce. There isn't enough of it to meet the demands of both options, so we need to make a decision on how to spend it. If going to the party was the next best choice, then the opportunity cost in this example was the fun time we would have at the party.
So a more complete and concise definition of opportunity cost would be:
The value placed on the next-best option, which was not chosen due to the scarcity of a resource.
Opportunity Cost Calculations and Formulas
While it's certainly possible to assemble an opportunity cost calculator, it's really not useful to the understanding of the concept. The same can be said for a mathematical formula; they're both impractical and cannot cover all of the possible opportunity cost scenarios.
For example, a worker making $20 per hour might decide to take unpaid leave from work to attend a graduation ceremony. In this example, the worker gave up $160 in pay ($20 per hour x 8 hours) in order to attend the ceremony. Here the opportunity cost was $160. In this example, the calculation of the opportunity cost was based on one day's pay.
In our second example, this same worker decides to use a vacation day to attend the graduation ceremony. In this example, the worker was saving that vacation day to go fishing. In this case, the opportunity cost was the loss of the fishing day.
These two examples demonstrate some of the many variations of an opportunity cost. They also demonstrate the reason it's impossible, and impractical, to create a formula or calculator to solve these problems.
Opportunity Cost Examples
As promised, we're going to finish this publication with examples from the economics, investing, as well as the business world. It should also be clear that examples exist pertaining to:
- Time Management - how to use your time
- Material Purchases - deciding which car to buy
- Careers - leaving a job at one company for a job at a new company
Opportunity Cost - Economic Example
In this example, a country has the ability to produce both guns and butter. Since resources are scarce, they can decide to offer their citizens more protection or food. The choice here is to have their economy produce more of one item over the other. If they produce more guns, then the opportunity cost is their ability to feed more people. If they produce more butter, then they might not be able to protect all their citizens if attacked.
Opportunity Cost - Investing Example
In this example, the investor has the ability to use their money to purchase shares of stock, or place the money in a certificate of deposit paying 5%. If they buy the stock, then the opportunity cost is the interest earned on the certificate of deposit. If they decide to invest in the certificate of deposit, then the opportunity cost would be any dividends paid, and the chance to realize a capital gain on their stock investment.
Opportunity Cost - Business Example
In this last example, a company has $1 million to spend. They could choose to purchase a more efficient machine to make toys, or they could spend the money to market the toy. If they decide to buy the machinery, then the opportunity cost is the lost sales of toys brought in by the advertising campaign. If they decide to spend the money on advertising, then the opportunity cost would be their ability to produce the toy more efficiently.
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