Meaning of Opportunity Cost
Opportunity Cost means the cost or price of the next best alternative available to a business, company, or investor. The next best choice refers to the option which has been foregone and not been chosen. Instead, another option, assuming it to be better and more rewarding and fruitful, has been selected. In other words, Opportunity Cost is the cost of the sacrifice of an available opportunity.
One important thing to keep in mind is the presence and availability of a feasible “option” to the decision-maker. If there is no option available, then there is no Opportunity Cost. Further, the available options should have an economic value. The foregone option may be a product or a service. These options can be anything- from taking production decisions to investment decisions. Also, they can be making a purchase decision to even valuing time spent on a particular activity.
Explicit and Implicit Cost
Explicit costs are the costs that a person or an entity incurs to avail of the benefit of an activity or service, or product. For example, if a producer gives US$50 as labor charges for a product, the explicit Cost is US$50. It means that the producer has lost an opportunity to spend this amount to buy some other product or service.
On the other hand, implicit opportunity costs are the costs that are notional or implied in nature. They are the costs of not choosing an available option. For example, the inherent opportunity cost of setting up a production unit is the loss of opportunity to invest the same amount of money in real estate and sell it after that.
Also, read – Explicit Vs. Implicit Cost
Importance of Opportunity Cost
The concept of Opportunity Cost is crucial in the world of business and finance. It explains the rationale of the economic decisions taken or chosen regarding the other available options.
Opportunity Cost provides a vital direction and guidance while deciding what to produce. It throws light on the following aspects:
- Opportunity Cost helps a manufacturer to determine whether to produce or not. He can assess the economic benefit of going for a production activity by comparing it with the option of not producing at all. He may invest the same amount of money, time, and resources in another business or Opportunity. Therefore, he will be able to decide which option gives him more returns and to opt for production or not.
- This concept enables a manufacturer to decide what to produce. The opportunity cost of building a product is the loss of the opportunity to provide another product. A producer may choose to go for product A after evaluating the benefits he will derive if he produces product B.
- A manufacturer may also assess the implicit opportunity cost of missing out on earning a salary income if he works elsewhere. It will give a fair idea of how much his time and resources are worth. Returns from manufacturing and business should be more than his assessed implicit Cost to stick to his business and not give up.
The concept of Opportunity cost is essential for making investments and related decisions.
- The opportunity cost of investing in house/land to avoid paying rentals may be a necessary factor for every business or individual. A person has to decide if he is better off by investing in his land or office space or continue paying rent for the same. He can compare the interest income he can earn from the money he will spend to buy the property or office space. If it is substantially more than the rentals he is paying, he can decide not to invest in land/house.
- The opportunity cost of investing in anything is the Missed Opportunity of investing in another option. For example, the opportunity cost of investing in Stock A is the loss of Opportunity of investing in Stock B or some other asset like gold. An investor will weigh all his available options and invest in the best possible option. However, factors like his willingness to take a risk to earn higher returns, maturity period, etc., will also be taken into account.
Calculation and Example
Opportunity Cost can simply be calculated by comparing the financial Cost of the next best possible option that has been foregone.
The opportunity cost of producing an item for US$10 is the loss of the Opportunity of buying that same item from the market. If that item is available at US$15 in the market, the producer is better off by producing the same. Hence, he will earn a profit of $5. But if the identical item is available for US$10 in the market, the producer will have to decide. He can continue production or simply buy the product from the market and sell it. Furthermore, if the same product is available for US$8 in the market, he can stop producing. Instead, he can buy the product and sell it.
Similarly, the opportunity cost of investing in Stock A for US$100 will be the loss of Opportunity of investing in Stock B for the same amount. If stock A rallies to US$150, and stock B remains the same in value, the investor gains US$50, and his decision to go for stock A is justified.
The world has limited availability of resources like land, labor, and capital. This scarcity of resources makes it very important to use a resource most efficiently and achieve maximum returns. The concept of Opportunity Cost helps us to choose the best possible option among all the available options. It helps us use every possible resource tactfully and efficiently and hence, maximize economic profits.
Quiz on Opportunity Costs
This quiz will help you to take a quick test of what you have read here.