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Opportunity Cost

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Opportunity Cost

You have to decide between going to a basketball game with your friends or studying for the test you have. Maybe this test you have is hard and you have to study for it. Maybe the basketball game has your favorite team and missing it will be the biggest regret of your life. Regardless of what you choose, you are utilizing an important economic concept known as opportunity cost. Ready to learn more? Then keep reading!

Opportunity Cost Definition

Opportunity cost is defined as the value foregone when making a specific choice. Opportunity cost looks to understand why decisions are made in day-to-day life. Whether big or small, economic decisions surround us everywhere we go. To better understand this value lost, we will discuss an important decision that some 18-year-olds will make: going to college.

Graduating high school is a great accomplishment, but now you have two options: going to college or working full-time. Let's say that college tuition will cost $10,000 dollars per year, and a full-time job will pay you $60,000 per year. The opportunity cost of going to college each year is foregoing the $60,000 you could have been making that year. If you work full-time, the opportunity cost is foregoing the potential earnings in a future position that only hires people with a degree. As you can see, this is no easy decision and one that requires great thought.

Opportunity Cost is the value foregone when making a specific choice.

Opportunity Cost A Typical College Library Opportunity Cost Definition Study SmarterA Typical College Library. Source: pixabay.com

Opportunity Cost Examples

We can also look at three examples of opportunity costs through a production possibility curve.

Opportunity Cost Example: Constant Opportunity Cost

Figure 1 below illustrates constant opportunity cost. But what does it tell us? We have two options for goods: oranges and apples. We can either produce 20 oranges and no apples, or 40 apples and no oranges.

Constant Opportunity Cost StudySmarter OriginalsFigure 1. Constant Opportunity Cost, StudySmarter Originals

To calculate the opportunity cost for producing 1 orange, we do the following calculation:

This calculation tells us that producing 1 orange has an opportunity cost of 2 apples. Alternatively, 1 apple has an opportunity cost of 1/2 an orange. The production possibilities curve shows us this as well. If we move from point A to point B, we must give up 10 oranges to produce 20 apples. If we move from point B to point C, we must give up 5 oranges to produce 10 additional apples. Finally, if we move from point C to point D, we must give up 5 oranges to produce 10 additional apples.

As you can see, the opportunity cost is the same along the line! This is because the production possibility curve (PPC) is a straight line — this gives us a constant opportunity cost. In the next example, we will relax this assumption to show a different opportunity cost.

The opportunity cost will also be equal to the slope of the PPC. In the graph above, the slope is equal to 2, which is the opportunity cost of producing 1 orange!

Opportunity Cost Example: Increasing Opportunity Cost

Let's take a look at another opportunity cost example on the production possibility curve.

Increasing Opportunity Cost StudySmarter OriginalsFigure 2. Increasing Opportunity Cost, StudySmarter Originals

What does the graph above tell us? We still only have two options for goods: oranges and apples. Initially, we can produce either 40 oranges and no apples, or 40 apples and no oranges. The key difference here is that we now have an increasing opportunity cost. The more apples we produce, the more oranges we have to give up. We can use the graph above to see the increasing opportunity cost.

If we move from point A to point B, we must give up 10 oranges to produce 25 apples. However, if we move from point B to point C, we must give up 30 oranges to produce 15 additional apples. We now have to give up more oranges to produce fewer apples.

Opportunity Cost Example: Decreasing Opportunity Cost

Let's take a look at our final example of opportunity cost on the production possibility curve.

Decreasing Opportunity Cost StudySmarter OriginalsFigure 3. Decreasing Opportunity Cost, StudySmarter Originals

What does the graph above tell us? We still only have two options for goods: oranges and apples. Initially, we can produce either 40 oranges and no apples, or 40 apples and no oranges. The key difference here is that we now have a decreasing opportunity cost. The more apples we produce, the fewer oranges we have to give up. We can use the graph above to see the decreasing opportunity cost.

If we move from point A to point B, we must give up 30 oranges to produce 15 apples. However, if we move from point B to point C, we must give up only 10 oranges to produce 25 additional apples. We are giving up fewer oranges to produce more apples.

Types of Opportunity Costs

There are also two types of opportunity costs: explicit and implicit opportunity costs. We will go over the differences between both.

Types of Opportunity Cost: Explicit Opportunity Cost

Explicit Opportunity Costs are direct monetary costs that are lost when making a decision. We will go into more detail in an example below.

Imagine you are deciding on whether to go to college or get a full-time job. Let's say you decide to go to college — the explicit opportunity cost of going to college is the income you miss out on by not taking the full-time job. You will likely make less money per year as a college student, and in some cases, have to take out student loans. That is a big cost to attending college!

Now, let's say you pick the full-time job. In the short term, you will make more money than a college student. But what about in the future? You may be able to increase your earnings with a college degree by getting a higher-skilled position. In this scenario, you miss out on increased future earnings you would have gotten if you went to college. In both instances, you are facing direct monetary costs to your decision.

Explicit Opportunity Costs are direct monetary costs that are lost when making a decision.

Types of Opportunity Cost: Implicit Opportunity Cost

Implicit Opportunity Costs do not consider the loss of direct monetary costs when making a decision. We will look at another example regarding spending time with your friends or studying for an exam.

Let's say you are nearing the end of your semester and finals are coming up. You are comfortable with all of your classes except for one: biology. You want to dedicate all of your time to studying for your biology exam, but your friends invite you to spend time with them. You are left to decide whether you want to spend time with your friends or study for your biology exam.

If you study for your exam, you are missing out on the fun you could be having with your friends. If you spend time with your friends, you are missing out on a potentially higher grade on your hardest exam. Here, the opportunity cost does not deal with direct monetary costs. Therefore, you have to decide which implicit opportunity cost is worth giving up.

Implicit Opportunity Costs are costs that do not consider the loss of direct monetary value when making a decision.

Formula for Calculating Opportunity Cost

Let's take a look at the formula for calculating opportunity cost.

To calculate an opportunity cost use the following formula:

Thinking about some opportunity cost examples we already went through, this makes sense. The opportunity cost is the value you lose based on the decision you make. Any value lost means that the return of the option not chosen is greater than the return of the option that was chosen.

Let's continue using our college example. If we decide to go to college instead of getting a full-time job, then the wages of the full-time job would be the return of the option not chosen, and the future earnings of a college degree would be the return of the option that was chosen.

The Importance of Opportunity Cost

Opportunity costs shape most decision-making in your life, even if you're not thinking about it. The decision to buy a dog or cat has an opportunity cost; deciding to buy new shoes or new pants has an opportunity cost; even the decision to drive further to a different grocery store you normally don't go to has an opportunity cost. Opportunity costs are truly everywhere.

Economists can use opportunity costs to understand human behavior in the market. Why do we decide to go to college over a full-time job? Why do we decide to buy gas-powered cars over electric? Economists can shape policy around how we make our decisions. If the main reason people do not go to college is high tuition costs, then policy can be shaped to lower prices and address that specific opportunity cost. Opportunity costs have a great impact not just on our decisions, but on the whole economy.


Opportunity Cost - Key Takeaways

  • The opportunity cost is the value foregone when making a specific choice.
  • There are two types of opportunity costs: explicit and implicit.
  • Explicit Opportunity Costs are direct monetary costs that are lost when making a decision.
  • Implicit Opportunity Costs do not consider the loss of direct monetary value when making a decision.
  • The formula for opportunity cost = Return of the option not chosen – Return of the option chosen.

Frequently Asked Questions about Opportunity Cost

Opportunity cost is the value foregone when making a specific choice.

An example of opportunity cost is deciding between going to college or working full-time. If you go to college, you miss out on the earnings of a full-time job.

The formula for opportunity cost is:

Opportunity Cost = Return of the option not chosen – Return of the option chosen

The concept of opportunity cost is recognizing the value foregone due to a decision you made.

The types of opportunity cost are: implicit and explicit opportunity cost.

Final Opportunity Cost Quiz

Question

What is an opportunity cost?

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Answer

The value foregone when you make a specific choice.

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What is the formula for calculating opportunity cost?

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The return of the option not chosen divided by the return of the option chosen.

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What are the two types of opportunity cost?

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Implicit and Explicit opportunity cost

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What is a constant opportunity cost?

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An opportunity cost that does not change.

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What is an implicit opportunity cost?

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An opportunity cost that does not consider the loss of direct monetary costs when making a decision.

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What is an explicit opportunity cost?

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Opportunity costs where direct monetary costs are lost when making a decision.

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What graph can we use to visually see an opportunity cost between two products?

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In a Production Possibility Curve, the opportunity cost of a product at a given point on the curve is the slope of the curve at that point.

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What does the slope on a production possibility curve equal?

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The opportunity cost.

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Question

Assume a constant opportunity cost: you can either produce 20 computers or 50 lamps. What is the opportunity cost of producing 1 computer?

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Answer

2.5 lamps

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Assume a constant opportunity cost: you can either produce 30 computers or 45 lamps. What is the opportunity cost of producing 1 computer?

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1.5 lamps

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Assume a constant opportunity cost: you can either produce 50 computers or 10 lamps. What is the opportunity cost of producing 1 computer?


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.2 lamps

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Assume a constant opportunity cost: you can either produce 30 computers or 90 lamps. What is the opportunity cost of producing 1 lamp?


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.33 computers

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Assume a constant opportunity cost: you can either produce 5 computers or 23 lamps. What is the opportunity cost of producing 1 lamp?


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.22 computers

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Assume a constant opportunity cost: you can either produce 80 computers or 80 lamps. What is the opportunity cost of producing 1 computer?


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1 lamp

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Assume a constant opportunity cost: you can either produce 75 computers or 30 lamps. What is the opportunity cost of producing 1 lamp?


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2.5 computers

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Let's say that college tuition will cost $10,000 dollars per year, and a full-time job will pay you $60,000 per year. What is the opportunity cost of going to college for four years?

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$240,000

($60,000 in lost salary per year for four years)

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What are the two types of opportunity costs?

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Implicit

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_____ opportunity costs are direct monetary costs that are lost when making a decision.

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Explicit

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_____ opportunity costs do not consider the loss of direct monetary costs when making a decision. 

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Implicit

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Question

If you go to a basketball game instead of studying for an exam, what is the opportunity cost of going to the game?

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Possibly a lower grade on your exam and maybe even a lower chance to get into your chosen college.

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If you study for your exam instead of going to the basketball game, what is the opportunity cost of studying?

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The fun you would have at the game. However, you would also save money!

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If you go to a football game instead of going fishing, what is the opportunity cost of going to the game?

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The fun you would have had fishing, the fish you would have caught, the taste of the fish you would have eaten, and the full feeling in your stomach after eating the fish. That's a lot of opportunity costs!

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What is the opportunity cost of watching a movie versus getting your car fixed?

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Having a fixed car that works properly

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What is the opportunity cost of going to your grandmother's house as opposed to hanging out with your friends?

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Whatever fun you would have had with your friends. But remember, you would likely gain some wisdom from your grandmother!

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If you study instead of playing video games, is there an opportunity cost to studying?

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Yes

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If you study instead of going to the beach, is there an opportunity cost to study?

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Yes

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If you study instead of lying in bed, is there an opportunity cost to study?

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Yes

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