Opportunity Cost

Opportunity cost is the value of the best alternative that's given up when making a decision. This article is set to uncover the essentials of this concept, providing a clear definition of opportunity cost, illustrating it with relatable examples, and exploring various types of opportunity costs. Furthermore, we'll unravel the formula for calculating opportunity cost and emphasize its importance in our everyday decision-making, in personal finance, and in business strategies. Dive in as we demystify the subtle yet crucial cost embedded in each choice we make.

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.

Fig. 1 - A Typical College Library

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 2 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.

Fig. 2 - Constant Opportunity Cost

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.

Opportunity Cost Example: Increasing Opportunity Cost

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

Fig. 3 - Increasing Opportunity Cost

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.

Fig. 4 - Decreasing opportunity cost

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.

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.

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.