Economics Terms A-Z
Opportunity cost refers to the loss of the next-best positive outcomes of a choice when an alternative decision is made. This cost does not only refer to money, but any lost benefits that the other choice could have bestowed. Opportunity costs are involved in every decision that is made, even if they are not obvious at first.
A simple example of this: the opportunity cost of using a machine to make one product (call it Product A) is the lost potential value of another product (Product B) that could have been made using the machine instead. That is, Product B cannot be produced, and its unrealized value is the opportunity cost of using the machine to make Product A.
If Product A is worth €50, and Product B is worth €35, then this opportunity cost for making Product A is €35 - €50 = -€15. For Product B, it is €50 - €35 = €15. This might seem confusing at first, but it makes logical sense. A suboptimal choice (Product B) should have a positive opportunity cost, because it eliminates the chance for a higher return by choosing the better alternative (Product A). Meanwhile, Product A’s opportunity cost is negative because the “cost” of choosing Product A is the “opportunity” to make a worse choice and lose money.
To extend this example, if the machine involved in production is specialized to only make Product A, it may seem like there is no opportunity cost involved in the production process. Since the machine couldn’t produce anything else anyway, no “sacrifice” of other products is needed.
However, this is not correct. The resources used as inputs for Product A have an opportunity cost of whatever next-best purpose they may have been used for. This opportunity cost is known as an implicit cost, since money is not actually exchanged. On the other hand, explicit costs are simply the money given out. In this case, the explicit cost is the price to buy the specialized machine.
You might be wondering where we stop counting additional opportunity costs. If this company sold Product A for €50, what is the opportunity cost? The lost chance to sell Product B for €35 instead? Or is it the lost chance to make and sell Product C for €15?
When we count opportunity cost, usually we only consider the “next-best” option. In this ongoing example, the opportunity cost of selling Product A is the profit from Product B that could have been made instead. We do not consider Product C or other alternatives.
This is because those other alternatives are worth less than Product B. If selling Product A was suddenly impossible, the rational, utility maximizing choice would be to sell Product B instead. Opportunity cost is concerned only with the next-best option, not every possibility under the sun. Thus, we do not need to consider Product C or other options less valuable than Product B.
A further application of opportunity cost is in international trade. The theory of comparative advantage states that it is most efficient for different countries to specialize their production in the goods that they have the lowest opportunity cost of producing. Then, they trade with other countries to acquire the other goods they need. In this way all countries benefit, and economic efficiency is achieved.
Good to Know
A good manager should always be considering business decisions in the context of the next best alternative. Even if a business move is profitable (in an accounting sense), without considering opportunity costs, it might not be the best choice available.
As an example, opportunity cost can be used in tandem with ROI and risk analysis to analyze business decisions. Risk measures the potential (expected) outcomes of a choice, while ROI measures the expected return of a choice compared to its cost of implementation. These are common methods used to compare options, choosing a low-risk, high-ROI option, ceteris paribus.
Opportunity cost adds context to this analysis by including a different perspective. Unlike risk analysis and ROI, it compares the actual outcomes of different choices to one another. Thus, the best choice is one with the lowest opportunity cost after accounting for the potential risk of each option, and the relative cost of implementing them.
Of course, it is impossible to know the actual cost or the actual risk of a decision before it is made. Thus, these analyses are never perfect unless they examine decisions or events that already took place. So, it is often quite difficult to know the actual opportunity costs before they occur!
Now, what was the opportunity cost to you for reading this article?