Opportunity cost

Key Takeaways

  1. Opportunity cost refers to the value a person could have received but passed up in pursuit of another option.
  2. Opportunity cost is vital while making smart business decisions. 

Opportunity cost is the cost of the next best option we pass up to invest in something. 

It arises because we choose specific investment instruments over others to put our funds. The choice we make considers two related components — risk (or safety) and magnitude of returns (high with riskier instruments and low with safer instruments). Opportunity cost tells us what another combination achieved that we may have missed out.

Opportunity cost meaning / what is the definition of opportunity cost

Opportunity cost is the value of benefit sacrificed in favor of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. Every decision we make has a cost assigned to it. If we give our time to do things we are good at, then we end up in a better position than if we focus on something else.

Opportunity Cost example

Many economists use this concept to determine if people can gain from trading one another. 

Let’s see an example. Assume 2 individuals Amy and John, UN agency manufacture 2 merchandise, apple, and fish. Amy and John face worse conditions once they attempt to do everything by themselves. If John offers all of his time to provide just one sensible, John will either gather ten apples or ten fish. And Amy will choose ten apples or catch twenty fish. John must favor one task. Once he decides to collect one apple, he offers up one fish. Therefore he will use that point to either choose apples or catch fish, and also, the value of that trade is one apple per fish. That’s John’s cost.

If we tend to apply the same logic with Amy, Amy’s cost would be one apple per pair of fish. In the time taken by Amy to collect one apple; at that point, she might have caught a couple of fish. Therefore John must surrender {only one|just one|only one} fish to choose one apple; however, Amy must surrender a pair of fish to collect one apple. From this, we can conclude that Amy’s cost is on top of John’s. If they’re allowed to trade with each other, they will be able to gain a lot of money if Amy focuses on catching, and John focuses on gathering apples.

Let’s see another example, consider a scenario in which your business anticipates a 10% return from the updated equipment over the next year while the predicted return on investment (ROI) in the stock market is 12% for the same period. The equipment has a 2% opportunity cost compared to the stock market (12% – 10%). In other words, by making an investment in the business, the company would forgo the opportunity to earn a larger return.

Importance of opportunity cost

Opportunity cost is a crucial component in economic and trade theory. Opportunity cost is vital while making smart business decisions. It helps the organization for effective resource allocation to maximize productivity. The businesses have multiple options to execute the daily operations, but it is essential to perform in the right way to gain the most from it.