Opportunity Cost

Opportunity cost definition

Opportunity cost is the value or cost of the potential alternative, that is abandoned in order to pursue a particular selected alternative.

This means, that opportunity cost is the cost of choosing one option over another. Opportunity cost is measured in the terms of the benefits that could have been gained from the abandoned alternative.

Opportunity cost is an important concept in economics and business decision-making process, as it helps decision makers making supported decisions and business choices by the way of comparing the benefits and costs of different possible alternatives.

Importance of opportunity cost concept

Supports decision-making process: opportunity cost helps decision makers making supported decisions and business choices by the way of comparing the benefits and costs of different possible alternatives.
Enables efficient use of resources: opportunity cost helps ensuring, that resources are used efficiently, bringing the maximum benefit for the business.
Helps in evaluating trade-offs: opportunity cost helps evaluating trade-offs between different alternatives. By comparing the opportunity cost of each possible alternative, decisions makers can make proper and supported decisions on the allocation of resources.

Types of opportunity cost

Explicit opportunity cost: this is an estimation of opportunity cost in the form of actual expenses to be incurred in case one of the possible options is selected. For example, in case one of the possible options to consider is purchase of a car, the explicit opportunity cost is the acquisition cost of the car, plus any additional expenses associated with this car owning and maintaining, such as fuel, insurance, and repairs.
Implicit opportunity cost: this type of the opportunity cannot be expressed in the form of actual expenses to be incurred for one of the possible options. This type of opportunity cost is rather represents the value of the benefits that could have been obtained from the other alternative, if that would have been chosen.

Both types of the opportunity cost are important in decision making process, since the represent complete analysis of potential benefits and costs of potential alternative decisions.

Opportunity cost formula

There is not formal formula, which can be used to calculate opportunity cost. However the following can be considered

Opportunity cost = Value (cost), of what is being given up – Value (cost) of what is being gained

Let’s check an example:

Let’s assume a person has the option to invest $10,000 in either Stock A or Stock B. If Stock A has a potential return of 8% and Stock B has a potential return of 10%, then the opportunity cost of choosing Stock A would be:
Opportunity cost of choosing Stock A = Return on Stock A – Return on Stock B = 8% – 10% = -2%
This means that by choosing Stock A, the person is giving up a potential 2% return that could have been earned if Stock B has been chosen instead.

Opportunity cost – example

Let’s check one more example of an opportunity cost concept:

Capital Investment: let’s assume a company is considering two different investment options:
Option A requires an investment of $100,000 and has a potential return of $150,000 over five years.
Option B requires an investment of $150,000 and has a potential return of $200,000 over the same period.

The opportunity cost of choosing Option A would be the $50,000 return, that could have been earned by choosing Option B instead.

Opportunity cost: key finding & main aspects to remember

Opportunity cost is the value or cost of a potential alternative that is abandoned to pursue a selected alternative
Opportunity cost is a cost of choosing one option over another and it is measured in terms of benefits, that could have been gained from the abandoned alternative
Opportunity cost is an important concept in economics and business decision-making for the purpose of comparing benefits and costs of different possible alternatives
Opportunity cost supports decision-making, enables efficient resource use, and helps in evaluating trade-offs
There are two types of opportunity cost: explicit and implicit
There is no formal formula to calculate opportunity cost, but it can be expressed as the value/cost of what is given up minus the value/cost of what is gained
Examples include choosing between two stocks with different potential returns or choosing between two investment options with different potential returns