What is Opportunity Cost?
The opportunity cost is the value of the best alternative choice when pursuing a certain action. In other words, the difference in the cost between what you chose to do and what you could have done.
Another way to look at it, is to ask yourself “If I do this, what will I have to give up?”
Throughout our lives we are faced with choices, and we have to chose one option each time. Before making the choice we weigh up all the alternatives and select one, hopefully with the most favorable opportunity cost, i.e. one that gives us the best return.
Opportunity cost is essentially the value of the next-highest-valued alternative use of that resource. It contrasts with absolute advantage, which compares productivity between one economy, company or individual with another. Comparative advantage is what a country, for example, should focus on after taking into account opportunity cost.
In business, opportunity cost is more to do with whether your choice was better/worse than the alternatives. In everyday life, it also includes looking at what you had to give up when you made a choice.
A simple real life example of opportunity cost would be spending time and money going to the theater, in this case the opportunity cost would be lost time at home watching TV and money that could have been spent on something else.
In economics it has been described as “the basic relationship between scarcity and choice”. It plays an important role in efficiently using scarce resources.
Example of opportunity cost in business
Imagine you bought some shares that over a 12-month period brought you a return of just 3%. By using up that money to buy those shares, you gave up the opportunity of an alternative investment, such as a risk-free government bond that yielded 5%.
In this case, your opportunity cost was (minus) -2% (what the shares gave you – minus – what the government bond would have given).
So, an opportunity cost can be calculated as:
What you did – minus – What you could have done.
The term was first coined by Austrian economist Friedrich von Wieser in 1914 in his book titled “Theorie der gesellschaftlichen Wirtschaft”. The actual concept was first described by French classical economist Frédéric Bastiat in 1848 in his essay “What Is Seen and What Is Not Seen”.
According to collinsdictionary.com, opportunity cost is:
“The benefit that could have been gained from an alternative use of the same resource.”
Shadow pricing, a way of estimating the cost of projects, programs, goods and services for which there is no market price, or if there are prices they do not reflect the sacrifices made, involves looking at the opportunity cost.