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 everyday decisions, as individuals are faced with making a choice between the many options encountered each day.
In this article, 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 demonstrating the concept of opportunity cost, and how it applies to economics, investing, as well as the business world.
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.
Individuals are faced with decisions between two or more choices all the time. For example, Haley might tell a friend she cannot make their party Saturday afternoon because she needs to attend her daughter's piano recital. Realistically, she's telling that friend that she's choosing to go to the recital, and passing on the opportunity to attend their party.
Haley needs to make this choice because she cannot be in two places at the same time. Her time is limited and scarce. There isn't enough of it to meet the demands of both options, so she needs to decide 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 she would have at the party.
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.
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 scenarios.
For example, a worker making $20 per hour might decide to take unpaid leave from work to attend a graduation ceremony. 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, and the calculation was based on one day's pay.
This same worker might decide to use a vacation day to attend the graduation ceremony. In this example, the worker was saving that vacation day to go fishing; so the opportunity cost was the loss of a day spent fishing.
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.
We're going to finish this topic with examples from the economics, investing, as well as the business world. The same thought process would also pertain to topic such as:
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 more 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.
In this next example, the investor has the ability 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, they lose the dividends paid, and the chance to realize a capital gain on their stock investment.
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, 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 they lose their ability to produce the toy more efficiently.
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