4.1.1.4 What is opportunity cost?

This study note looks at opportunity cost.

Opportunity cost is a concept that's central to economics. It refers to the cost of the next best alternative when making a decision. For example, let's say you're deciding whether to spend an hour studying or watching TV. If you choose to study, your opportunity cost is the enjoyment you could have gotten from watching TV. If you choose to watch TV, your opportunity cost is the knowledge you could have gained from studying. Opportunity cost is important because it helps us to understand the true cost of our choices and make the most efficient decisions.

Opportunity cost is a fundamental concept in economics that refers to the value of the next best alternative foregone when a decision is made to allocate resources (such as time, money, or labor) to a particular choice or activity. In other words, it's the cost of what you give up when you choose one option over another. Here are some examples to illustrate the concept of opportunity cost:

1. Education vs. Employment: Imagine a high school graduate who is deciding whether to pursue a college education or enter the workforce directly. If they choose to attend college, the direct costs include tuition, books, and foregone income (because they're not working). However, the opportunity cost is the potential income they could have earned if they had chosen to work immediately.

   Example: If the student decides to go to college and incurs $20,000 in tuition expenses over four years while not working, their opportunity cost would be the income they could have earned during those four years if they had started working right away, which might be, say, $15,000 per year. So, the total opportunity cost would be $60,000 ($15,000/year x 4 years).

2. Investment Choices: Suppose an individual has $10,000 to invest, and they are considering two options: investing in stocks or bonds. If they choose to invest in stocks and earn a 10% return, the opportunity cost is the potential return they could have earned from bonds, which might offer a safer but lower return, say 5%.

   Example: If they invest in stocks and earn a 10% return, they would gain $1,000 (10% of $10,000). However, if they had chosen bonds, they could have earned $500 (5% of $10,000). Therefore, the opportunity cost of choosing stocks over bonds in this case is $500.

3. Time Allocation: Consider a business owner who has a limited amount of time each day and has to decide between working on a new marketing campaign or focusing on product development. If they choose to work on marketing, the opportunity cost is the potential progress or profit they could have made by allocating their time to product development instead.

   Example: If the business owner spends a day working on marketing and generates $500 in sales from the campaign, but they estimate that working on product development could have generated $1,000 in sales, the opportunity cost of their choice is $500.

In all these examples, opportunity cost highlights the importance of considering not only the explicit costs of a decision but also what could have been gained by choosing an alternative course of action. It emphasizes the idea that resources are scarce, and choices involve trade-offs. Understanding opportunity cost is essential for making informed decisions in both personal and economic contexts, as it helps individuals and businesses assess the full implications of their choices.