Opportunity Cost Explained

Opportunity cost of a resource is referred to as the value of the next-highest-valued alternative use of that resource. Sounds way too technical, doesn’t it? Let’s try to simplify its meaning with an example.

Suppose, at the ice cream parlor, you have to choose between choco chip and black current. If you choose choco chip, the opportunity cost will be the enjoyment you might get to consuming black current. Still confused, no worries. We have got it covered for you!

By the way, make sure you read our recent blog on “How to make money using debt?” for some insightful information.

Let’s take some more instances.

  1. The opportunity cost of going on a vacation instead of spending the money on a new car is not getting a new car.
  2. Jack has $20,000 worth of stock that he can sell for $25,000. He wanted to wait for two months before selling it because the stock prices were expected to take a surge. However, due to some reasons, he is selling them right now. Poor jack! The opportunity cost in this case would be determined in the coming two months. It would be a difference between the $25,000 and the price she would have gotten if he sold the stock then.
  3. Caroline buys a pizza with the same amount of money by which she could have bought a soft drink and a burger. The opportunity cost in this case is the drink and hot dog.
  4. If the government offers an income tax cut, the opportunity cost is that government revenue cannot be used to finance some aspects of government spending.

You must have noticed that in all the instances mentioned above, there is always a sacrifice involved. The resource which gets sacrificed becomes the opportunity cost- the next best alternative. Guess it is true when they say that you cannot have it both ways !

Relevance and importance of opportunity cost:

Opportunity cost is significant as the fundamental problem of economics persists, which is called scarcity. Owing to which, economists insist upon the optimal use and distribution of these scarce resources. Wherever there is scarcity we are forced to make choices. If we have £20, we can spend it on an economic textbook, or we can enjoy a meal in a restaurant. Yes, we know life sucks. Is it just us, or do you think that the word ‘opportunity’ in opportunity cost is redundant too?  

Types of Opportunity Costs:

Opportunity Cost can be divided into- Explicit and Implicit cost.

  1. Explicit Cost: Explicit costs include a financial payment. They are direct, out-of-pocket payments such as wages, utilities, materials, or rent.
  2. Implicit Cost: Implicit costs do not represent a financial payment. Instead, implicit costs concern resources you already own. It is not a direct cost to you, but rather the lost opportunity to generate income through those resources.

The goal of studying the concept of opportunity cost is not to make yourself constantly second guess your actions or strategy, but to make sure you are cognizant that your choices do have consequences. Always consider the opportunity cost, but once you have made a decision, have faith in that decision.