Jul 26, 2017
Definition of Opportunity Cost in Economics & Finance
We all understand the concept of cost because we face it daily. For example, the cost of a gallon of gas or the cost of a Big Mac are easily understandable as these costs are measured in dollars and cents. Economists have another cost concept that you may be less familiar with called Opportunity Cost. Opportunity Cost is the value of the next best alternative choice you could have made instead of the actual choice you made.
This definition is the one you will find most textbooks, but what exactly does this mean? Let’s break it down.
A Simple Explanation and Breakdown of Opportunity Cost
“Opportunity Cost is the value of the next best alternative choice you could have made instead of the actual choice you made.”
The concept of “value” is somewhat arbitrary because economists do not necessarily measure it only with money. Value could also be the pleasure or benefit you receive from choosing one activity over another, such as watching TV at home or going for a walk, or choosing to eat a pizza or a hamburger (assuming you like both).
The “value of the next best alternative” simply means the value of the next best thing you could have chosen when you had the choice between two or more alternatives. To picture this in real life, let’s pretend you go to a restaurant that serves both hamburgers and pizzas both at the same price of $1. After a long day at work, you think about how delicious it would be to eat either a pizza or a hamburger. You are hungry, but not hungry enough to eat both. After various minutes of indecision, you finally decide you will have pizza instead of a hamburger. When the check comes you see the monetary cost of eating the pizza was simply $1 but the opportunity cost of eating the pizza was the pleasure or benefit foregone by not eating the hamburger.
Opportunity Cost is the lost benefit, pleasure or satisfaction you sacrifice (in this case the joy of eating a hamburger) by not doing, eating or taking the next best alternative or choice. When you chose to eat the pizza instead of the hamburger, all this means is that the benefits or pleasure of eating pizza outweighed the benefits of eating a hamburger.
One of the key concepts involving opportunity costs is that it does not matter how many alternative choices exist. This is because you are only concerned about the potential benefit of the next best choice. So it does not matter if you have one alternative choice or 100 different choices. Opportunity cost only looks at the value of the next best alternative and what value you are sacrificing by choosing one option over another.
Opportunity Cost in Finance and Economics
Opportunity Cost in Economics
Business must often deal with the concept of Opportunity Cost. For example, a manufacturer or the owner of a workshop could chose to make rocking chairs or clocks or a combination of both. Whichever she chooses, she must effectively allocate scarce resources to achieve the optimal result of maximizing profits. Let’s say that this manufacturer is relatively better at making rocking chairs instead of clocks. In order to make more clocks, some scarce resources such as labor and manufacturing floorspace will need to be diverted away from producing rocking chairs to efficiently manufacture clocks. In this example, the manufacturer will need to carefully consider the opportunity cost of making fewer rocking chairs compared to the benefit of making more clocks. Choosing one option inevitably means sacrificing another, so the manufacturer needs to consider what is being sacrificed in making one choice over another.
Opportunity Cost in Finance
Investors also face opportunity costs. When investors chose to buy one Exchange Traded Fund (ETF) over another they must consider what is being sacrificed by taking this course of action rather than another. For example, one ETF may have high growth potential while another pays high dividends. If the investor chooses to buy the growth ETF he must consider the opportunity cost of sacrificing the dividends. These dividends could have been used for alternative investments earning a higher return elsewhere or they could be used to supplement income and reduce the need for an investor to work in the future.
By sacrificing a dividend ETF for a growth ETF, our investor would need to believe that the potential return on some alternative investment (in this case the dividend investment) is less than the potential future return from the growth ETF. Alternatively, if the investor chooses to buy the dividend paying ETF then she must consider the opportunity cost of sacrificing the potential future capital gains of the growth ETF.
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