Imagine the following scenario. You have 2$ and you want to buy bar chocolates. You are in the situation to choose between Snickers bars and Mars ones, so you have to forgo one of the products. The opportunity cost will be the product that you give up on buying.
So, in a more theoretical manner, opportunity cost refers to the value of the next best alternative that must be forgone as a result of making a decision to choose one option over others. In simpler terms, it is the cost of passing up the next best choice when making a decision.
For another example, let’s imagine you can spend your time either watching a film or studying, the opportunity cost of an hour watching the film is the hour of studying you give up to do that.
There are two types of opportunity costs: explicit and implicit. The explicit opportunity costs represent economic decisions and include: wages, materials, stock purchases, rent, utilities and other tangible expenses. Any dollar amount required for a specific decision is considered explicit costs. On the other hand, implicit opportunity costs may not derive from specific actions, so can’t be quantified in monetary terms. They include intangible factors such as time, satisfaction or potential benefits. So remember: time can be seen from the opportunity cost perspective! Choosing to spend time on one activity means forgoing the opportunity to use that time for another potentially beneficial activity.
Why should we understand opportunity cost as individuals? Because we make decisions every day and we should learn to allocate our resources, time and money correctly between different options we may have. In the case of businesses, by assessing the potential benefits and drawbacks of different choices, they can maximize their profits and make more informed and efficient decisions. So, considering the opportunity cost allows us to see the most profitable option to invest in and makes the decision process a lot easier.
Moreover, opportunity cost is a different concept and doesn’t mean risk. In economics, risk describes the possibility that an investment’s actual and projected returns are different and that the investor loses some or all of the principal. The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of another investment.
Now that you have understood the concept, let’s look at a fun fact! In 1962, band “The Beatles” auditioned for Decca Records, but the label decided against signing them. The decision would have been made because the opportunity cost to sign them didn’t outweigh the opportunity cost to pass on them. This was clearly a decision that the label must have regretted since the band proved to be very successful!
You reached the end of the article, so take a minute to consider the decisions you are facing currently in your life. What is the opportunity cost for them?
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