The consideration of opportunity cost remains an important aspect of decision making, but it isn’t accurate until the choice has been made and you can look back to compare how the two investments performed. You chose to read this article instead of reading another article, checking your Facebook page, or watching television. Your life is the result of your past decisions, and that, essentially, is the definition of opportunity cost.
Michael Munger of Duke University and host Russ Roberts talk about the economics of ticket scalping, examining our reactions to free and found goods, gifts, e-Bay, value in use vs. value in exchange, and opportunity costs. Economics has been called the dismal science because it studies the most fundamental of all problems, scarcity. Because of scarcity we all face the dismal reality that there are limits to what we can do. No matter how productive we become, we can never accomplish and enjoy as much as we would like. Because of scarcity, every time we do one thing we necessarily have to forgo doing something else desirable.
- Economically speaking, though, opportunity costs are still very real.
- The opportunity cost is the value of the next best alternative foregone.
- For businesses, economic profit is the amount of money made after deducting both explicit and implicit costs.
Opportunity cost is the value of the next best alternative or option. Value can also be measured by other means like time or satisfaction. In short, opportunity cost can be described as the cost of something you didn’t choose.
What is the time value of money?
Economic profit does not indicate whether or not a business decision will make money. It signifies if it is prudent to undertake a specific decision against the opportunity of undertaking a different decision. As shown in the simplified example in the image, choosing to start a business would provide $10,000 in terms of accounting profits. However, the decision to start a business would provide -$30,000 in terms of economic profits, indicating that the decision to start a business may not be prudent as the opportunity costs outweigh the profit from starting a business. The concept of opportunity cost is one of the most important ideas in
economics. Consider the question, “How much does it cost to go to
college for a year?
- An author, teacher & investing expert with nearly two decades experience as an investment portfolio manager and chief financial officer for a real estate holding company.
- The primary limitation of opportunity cost is that it is difficult to accurately estimate future returns.
- Businesses can also apply the concept of opportunity costs, but they tend to call it economic costs.
- Tuition and fees are not, for most college students, the major cost of going to college.
- These supply issues are now easing thanks to years of market shaping efforts to develop a more robust HPV vaccine market, and the single dose recommendation.
A sunk cost is money already spent in the past, while opportunity cost is the potential returns not earned in the future on an investment because the capital was invested elsewhere. When considering opportunity cost, any sunk costs previously incurred are ignored unless there are specific variable outcomes related to those funds. Furthermore, the information presented does not take into consideration commissions, tax implications, or other transactional costs, which may significantly affect the economic consequences of a given strategy or investment decision. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.
The Formula of Opportunity Cost & How to Calculate It
Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision.
Opportunity Cost and Societal Decisions
Opportunity cost refers to what you have to give up to buy what you want in terms of other goods or services. When economists use the word “cost,” we usually mean opportunity cost. A land surveyor determines that the single step income statement land can be sold at a price of $40 billion. A consultant determines that extracting the oil will generate an operating revenue of $80 billion in present value terms if the firm is willing to invest $30 billion today.
This work, along with other studies, is captured in this special collection. Remember that all investing carries risk, and you can lose money in the market. Stash recommends diversifying when you invest, and following the Stash Way. A diversified portfolio can have a mix of stocks, bonds, and exchange-traded funds (ETFs). There is no specifically defined or agreed on mathematical formula to calculate opportunity cost, but there are ways to think about opportunity costs in a mathematical way.
How To Calculate Opportunity Cost
The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50 billion. However, the economic profit for choosing to extract will be $10 billion because the opportunity cost of not selling the land will be $40 billion. Despite the fact that sunk costs should be ignored when making future decisions, people sometimes make the mistake of thinking sunk cost matters.
So there is an opportunity cost to everything we do, and that cost is expressed in terms of the most valuable alternative that is sacrificed…. When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book…. The decision in this situation would be to continue production as the $50 billion in expected revenue is still greater than the $40 billion received from selling the land.
Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively highly paid businesspeople, conservative estimates set the average “price of time” for air travelers at $20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × $20/hour—or, $8 billion per year. Clearly, the opportunity costs of waiting time can be just as substantial as costs involving direct spending.
Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. The primary limitation of opportunity cost is that it is difficult to accurately estimate future returns. You can study historical data to give yourself a better idea of how an investment will perform, but you can never predict an investment’s performance with 100% accuracy. You can also consider the opportunity costs when deciding how to spend your time. He decides to close his office one afternoon to paint the office himself, thinking that he’s saving money on the costs of hiring professional painters.
But once you understand opportunity cost is a factor you should weigh, the amount of opportunities to consider may seem intimidating. You don’t want to choose the wrong investment option and incur the wrong opportunity cost, after all. Everyday examples of opportunity costs might include choosing to commute using public transit for 80 minutes instead of driving for 40 minutes. You might save on the cost of gas but double the trip length and miss out on other things you could have done during that time. When calculating opportunity costs, it’s important to consider more than just flat returns, however.
That’s not to say that your past decisions have no effect on your future decisions, of course. You’ll still have to pay off your student loans whether or not you continue in your chosen field or decide to go back to school for more education. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs. The investment information provided in this table is for informational and general educational purposes only and should not be construed as investment or financial advice.