What Is Opportunity Cost? An Essential Economic Principle Explained
Opportunity cost is an essential concept in economics that describes the cost of making one decision over another. To fully understand the concept, it is useful to start by breaking down the components of the definition. From the words “opportunity” and “cost,” we can draw two pertinent definitions:
Opportunity:
A favorable or advantageous combination of circumstances.
Cost:
The expense involved with the production, acquisition, or sacrifice of something.
When these definitions are fused together, you end up with “opportunity cost,” which broadly refers to the value of something that was forgone or sacrificed when making a decision. When discussing opportunity cost in economic terms, the concept seeks to assess the cost of selecting a certain route over the cost of an alternative route.
In order to help define opportunity cost in an economic sense, we need to differentiate it from certain other related economic terms. On one hand, there are terms like marginal cost and explicit cost, which refer to the cost of completing a certain task. On the other, there are terms like implicit cost, which refer to the cost of a potential opportunity that must be foregone due to a lack of resources available.
In both cases, the cost incurred is of a tangible nature and does not necessarily refer to the cost of forgoing an opportunity. To properly understand opportunity cost, it must be understood on its own separate terms.
Understanding the Cost of Opportunity
In order to properly understand opportunity cost, it is important to understand how it differs from the other cost concepts mentioned previously.
The first point to understand is that opportunity cost is a subjective concept. More specifically, it is subjective in that it is only relevant when a decision must be made between two or more options. Consequently, opportunity cost is only incurred in situations where there is an opportunity that must be sacrificed in order to pursue an alternative route.
The second point to keep in mind is that opportunity cost is related to the concept of forgone gains. In other words, the concept helps to quantify the profit or value that was lost by not pursuing the missed opportunity. As a result, the cost of opportunity is the cost of those forgone gains.
The third point to consider is that opportunity cost is not necessarily a “cost” in the same way that marginal cost is. Instead, opportunity cost is more accurately thought of as an “opportunity assessment” that helps to gauge the relative or comparative value of two options.
Opportunity Cost in Action
The concept of opportunity cost can be best illustrated through an example that highlights the relative value of two different options.
Let’s assume you are an entrepreneur with a start-up venture and you are faced with two options for securing a business loan:
Option A: Borrow the capital with high interest rates
Option B: Secure an investment from a private investor.
Let’s also assume that there are varying time frames associated with each option. Option A might provide you with instant capital, while option B might take more time to lock in the investor.
In order to properly assess your options, you must consider the opportunity cost of each one. More specifically, you must determine which option provides the most value in terms of the time and the rate of return.
In this example, the opportunity cost of option A is the forgone return (or opportunity) that was associated with taking on the private investor. Conversely, the opportunity cost of option B is the forgone chance to acquire the capital quickly, as well as the return associated with the higher interest rate.
Ultimately, the decision you make as an entrepreneur must be based on the opportunity cost of each option.
Implications Of Opportunity Cost
Opportunity cost has many implications for both individuals and organizations. On a personal level, opportunity cost is pertinent to decisions related to finances, career, education and leisure. The concept helps the individual to assess the relative value of two scenarios, and ultimately decide on the best course of action.
On the organizational level, the concept of opportunity cost is even more important. Organizations must often consider the implications of pursuing one course of action over another, and the cost of those opportunities. For example, a company might have to decide between investing in a certain technology, versus investing in a new product line.
In both cases, the company needs to consider the associated opportunity cost of each option. By doing so, the company can start to gain insight into the actual cost and value of the options.
Opportunity cost is an important concept in economics that helps to quantify the relative or comparative value of two options. The concept involves assessing the cost of forgoing an opportunity in order to pursue an alternative route.
When considering the implications of opportunity cost, it is important to note that the concept involves elements of both rational assessment and forward-looking decision-making. Individuals and organizations can use the concept to gain insight into the actual cost of selecting a certain option and to better weigh the pros and cons of each option.
Ultimately, understanding and applying the concept of opportunity cost can help individuals and organizations make better decisions as they evaluate their options.
