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What is opportunity cost?
Opportunity cost is simply the value of the alternative foregone. It represents the ability for an individual, investors, or businesses from the alternative they miss out on while trying to choose one over the other. Opportunity cost is a major concept in Economics. When economists use the word ‘cost’, they are actually referring to opportunity cost.
The term also means what one has to let go of to buy what he wants in the aspect of other goods and services. Therefore, it is the benefit one forgoes that he would have derived by making the choice he did not make. In other words, the decision-maker would have enjoyed the benefit of choosing that option. This implies the real cost of the choices we make.
Looking at the definition, they are not seen, and because of that, one can easily overlook it if he is not careful. The ability to understand the potential missed opportunities foregone by making a choice of one investment over another provides a forum for better decision-making.
In order to properly assess opportunity costs, the decision-maker must weigh the costs and benefits of the option he wants to take against another. Considering this factor can help guide both individuals, businesses, and investors to make more profitable decisions.
Though financial reports do not show opportunity costs, businesses usually use the concept to make wise and intelligent decisions when they are faced with multiple options. Bottlenecks for instance usually amount to opportunity costs. Bottleneck means a point of congestion in carrying out production processes, especially when the producing firm has a limited production capacity.
Examples of opportunity cost
One example is a student who has $20 and has to choose what to buy with it. He may choose to buy a book with it instead of a pair of shoes. The opportunity cost of the book he purchases is the pair of shoes he had to forgo. Probably the student needed a pair of shoes for school and at the same time needed to buy a book for his academic activities. We can assume that he weighed the benefits and costs of the two alternatives before arriving at the decision of buying a book.
We cannot possess everything we want in life, this is the area where the concept of scarcity steps in. Our wants are unlimited but the resources to satisfy these wants are limited. This limited supply of resources includes the supply of goods, services, time, money, and opportunities. This concept is a driving force of choices. This is clear in the above example.
A student who spends two hours, thirty minutes, and $15 at a cinema a night before his exam. The opportunity cost, in this case, is the time he will spend studying and the money he will use to buy another thing instead.
For a farmer who chooses to cultivate coffee, the opportunity cost is cultivating a different crop. It can also be an alternative use of resources such as land and farm equipment.
An employee who goes to work and spends 10 hours daily at work. His opportunity cost is the hours he spends somewhere else, probably having a tour with friends or practicing a musical instrument.
The problem comes up if one is not able to look at what else he can use his money, time, and other resources for without taking the lost opportunities into consideration. This concept applies to every facet of our lives in our daily living. There are times that we have to let go of certain pleasures to meet up certain needs.
For example, you let go of extravagant spendings that possesses certain utility to save more for the future or invest for more returns.
Types of opportunity cost
They are of two major types namely;
- Implicit cost
- Explicit cost
We have looked at opportunity cost as the value of the (best) alternative forgone. As explained above, the concept also has to do with some monetary transaction or compensation. In some instances, there is no monetary compensation or otherwise. The difference between the two is what gives rise to the two types of opportunity cost (implicit and explicit).
This is an opportunity cost that has nothing to do with money payment or market transactions. Whoever is incurring this opportunity cost does not receive monetary compensation and does not transfer the cost to another person. This has to do with the example given above with an employee who goes to work and spends 10 hours daily. He has to forgo the satisfaction or pleasure he derives from having a tour with friends, rehearsing a musical instrument, and playing games. In this case, the employee is incurring an implicit cost.
This is an opportunity cost that has to do with monetary payment and market transactions. Whoever is incurring this cost receives monetary compensation and forgoes the satisfaction. In this sense, the payment/compensation transfers the opportunity cost from one person to the other. That is a transfer of cost from the original person to the person making the payment.
Using the above example of an employee who works for 10 hours daily. While at work, he forgoes his leisure time (hanging out with friends, playing games, and practicing a musical instrument). He is the one who directly incurs the opportunity cost from his job. Here, he receives a periodic payment for his time. This employee has transferred his cost to the employer in monetary terms. In other words, he receives monetary payment/compensation for his time at work.
Opportunity cost formula
We determine opportunity cost using the following formula is the difference between the expected returns of each alternative, that is the expected return of the choice taken and the expected return of the choice foregone. For instance, you have two options: Option A, invest in a stock exchange market with an expectation to generate capital gain returns. Option B, Invest your capital back into the business with an expectation that newer equipment will help increase the efficiency of production, leading to lower operational expenses and a higher profit margin.
The formula is expressed as;
OC = FO − CO Where,
OC = Opportunity cost
FO = Return on best-foregone option
CO=Return on the chosen option
How to find opportunity cost – Calculation
Let us assume that the expected return on investment/capital gain returns in the stock exchange market is 15%. The new equipment in the second option is expected to generate 12% of returns over the same period.
The opportunity cost of choosing the second option over the first is;
15% – 12% = 3%
This means that by you investing in the business, you will the opportunity of earning higher returns.
In essence, this is basically how to calculate opportunity cost.
Importance of opportunity cost
Opportunity cost is important to different groups of people in our daily lines. It is of utmost importance in the decision-making of individuals, businesses, investors, and the ordinary man. This is because each category needs to take a close look at the concept before arriving at a decision.
Opportunity cost helps in providing sensitive guidance and direction in the course of deciding what to produce. It enlightens producers in the following areas;
- It helps a manufacturing firm to ascertain whether to produce a particular commodity or not. The producer can easily assess the economic advantages and benefits of choosing a production activity by comparing it with the option of not doing the production at all. He can decide to invest the same amount of money, time, and resources in a different business or opportunity. With this, he can therefore decide the option that gives him higher returns and to embark on the production or not.
- It helps a producer to decide what to produce, the opportunity cost of producing a commodity means the loss of opportunity in producing another commodity. A producer can choose to embark on producing commodity X after he has evaluated the benefits and costs of producing commodity Y.
- Also, a producer can evaluate the implicit cost of him missing out on earning wage/salary income if he decides to work somewhere else. The analysis gives a just of the worth of his time and resources. Generating returns from production and business should be greater than the implicit cost he (producer) assessed. This is for him to hold on to his business and not to give up.
This concept is also relevant in making vital decisions that relate to making investments.
Making an investment in house or land in order to avoid paying rent could be necessary for every individual or business. One should decide if he is better off by investing in his housing/office/land or keep paying rent for those factors. Here, you can compare the income or revenue you can generate from the money you will spend in buying the land. If his returns will be low, then he can decide not to invest in the land/housing property.
The opportunity cost of investing in anything is the opportunity that an investor misses by choosing to invest in another option. For example, investing in Stock X implies losing the opportunity of investing in Stock Y or other assets. An investor has to weigh all his available options and then invest in the best option that is possible. It is also necessary for him to take into consideration the risk he has to face to generate higher returns. He should also consider the maturity period.
The ordinary person
The concept is also important to an ordinary person because it applies to our daily lives. It is not possible for one to possess everything he needs in this life. You have to let go of one thing for you to get the other. We can see an example with a student who was faced with two options, a book and a pair of shoes. He weighed the benefits and costs of buying a book and buying a pair of shoes. After weighing the costs and benefits of the two options, he arrived at buying a book. We can see that it is important for one to consider these factors very closely in order to make wise and profitable decisions.
For someone who wants to possess necessities of life like food, clothing, and shelter also. He can have two options; not getting a job, just sleeping, and enjoying leisure time. The second is forfeiting those pleasures of leisure time, going out to work in order to receive a payment. A sensible person will forgo his leisure time, work, and meet his needs (necessities of life).
This concept outlines the basic problems of scarcity and choice in the economy. It is relevant to the behavior of individuals or consumers/consumer behavior. Also, the concept applies to the behavior of manufacturing firms as we have seen above, and even the government.
It discloses that every human activity that has to do with economic decisions implies some real costs which we measure in terms of forgone alternatives.
Opportunity Cost and Capital Structure
This concept plays a vital role in ascertaining the capital structure of a business. A firm that incurs an expense in issuing debt and equity capital to compensate lenders and shareholders. This compensation is for the risk of investment. Each of these factors possesses an opportunity cost. For example, firms cannot invest the funds they use to pay for loans in stock or bonds. Though this provides a potential income or returns on investment. The firm has to decide if the expansion will generate higher profit than the investment. this expansion is the one that the compounding power of debt amounts to.
Here, a firm tries to weigh the costs and benefits of issuing debts and stock. This includes both monetary and non-monetary considerations. This is to arrive at a favorable balance that helps to minimize opportunity costs.
Therefore, it is important to compare the available investment options that possess similar risks.
In the course of assessing the profitability of different investments, businesses look for the option that tends to yield the highest return. Usually, they can ascertain this by taking a close look at the expected rate of return for an investment driver. Also, the business must, however, consider the opportunity cost of each option.
For example, a business has a particular amount of money for investment. It must choose between investing that money in securities or using the money to purchase new equipment. Regardless of the option, the business decides to take, the profit it gives up by not investing in the other option is the opportunity cost. This implies that we cannot avoid this concept in our daily living.
Opportunity cost and price
The money cost of a commodity is the price at which one purchases that commodity. For example, a shirt costs $10, that is the money cost (price) of that shirt. The real cost of the shirt is the opportunity cost. This is the closest alternative the buyer had to forgo in order to obtain the shirt.
As we have seen above, we express opportunity cost in relative price, that is, the price of an alternative relative to another. From the example above, the relative price gives a clearer picture of the real cost of the commodity than the monetary cost does. This is basically the explicit cost. Monetary value or price has nothing to do with the implicit cost of an alternative.
Looking at this concept closely, it relates to the scale of preference which also involves price. Economists have assumed that human beings behave rationally. They want to satisfy their most pressing wants than the less pressing ones. Every individual has all he wants in the order of preference. The most pressing wants would come first while the least pressing ones will come last. This is because of the limited resources available to acquire those resources. Never forget that these limited resources we are talking about are monetary resources. This also involves price.
According to the price of the products, the buyer will start from the most preferred and stop where his money finishes. This is in the order of preference. In essence, opportunity cost, price, and scale of preference are interrelated.
Risk vs. Opportunity Cost
Risk in economics describes the likelihood that the projected and actual returns on investment will be different. Also, that the investor is bound to lose some or all of his principal. Opportunity cost places concern on the likelihood that the returns of the investment one choose are less than the returns of the investment he forgoes. The risk here compares the difference between the actual performance of an investment over the projected performance of that investment. On the other hand, opportunity cost compares the actual performance of an investment over the actual performance of another different investment.
The opportunity cost of holding money
When we talk about the opportunity cost of holding money, it is the cost that one can realize if he invests money instead of holding it. This could be investors, businesses, or individuals. We can also say that it is the interest rate that money is earning in a particular chosen investment. This is an interest rate on bonds, especially government bonds. Among other choices of investment that one can make, this cost can vary among individuals or business entities.
In determining the actual opportunity cost of holding money, one should determine what the investment would be. Next, you make research on the interest rate that will be on that investment strategy. If the yearly rate is a single percentage, the annual single percent will then be the opportunity cost of holding money. To assign a definite value, this first of all requires that one knows how much money he is holding and for how long he will hold it.
In economics, we refer to holding money and investing money as mutually exclusive choices. Just like the probability theory in mathematics (mutually exclusive events), one cannot do them both at the same time with the same money. If you invest money, then it means that you cannot hold it. Though it tends to be possible for one to change his decision with respect to the choice for that money, he cannot adopt those strategies at the same time.
Understanding opportunity cost of holding money
Most businesses are bound to feel as if they will better have their money working for them than just holding it, there can be justifiable reasons for not investing. One of the reasons can be the fact that holding money gives a business a certain rate of economic freedom. This is because the capital is relatively liquid, that is the working capital. It gives a business room to make prompt decisions with some of the funds at its disposal. In essence, holding money seems to involve less risk than investing it. The business choices vary among businesses, this depends on their goals and objectives.
Just as we have looked at explicit costs, we can consider an opportunity cost of holding money to fall within that category. This implies that it is a cost that a business loses because of the lack of use of its own resources in the monetary aspect. For a business to determine whether an opportunity cost of holding money is worth it or not, it has to look at different factors. For instance, the business can work on a product or purchase that will help it to be able to make better returns on investment than the current interest rates. I this instance, it is better to hold on to the money. Deciding on the best strategy usually implies acting beforehand and measuring every explicit cost.
In conclusion, we can say that the opportunity cost for holding money is the forgone interest on an alternative asset. It is the nominal interest because it is the sum of the actual/real interest rate on an alternative asset, adding the expected inflation rate.
Here is a video that explains the opportunity cost:
In conclusion, we can conclude that opportunity cost is the value of the alternative you have to forfeit to go for other. It is inevitable in our daily lives because we cannot have everything we want in life. That is why it is important to weigh the costs and benefits of each option to make viable decisions.