Opportunity cost is the value of the next best alternative that is given up as a result of making a particular decision. It is the cost of a choice that is measured in terms of the benefits that are forgone as a result of that choice.
In making decisions, we often face constraints such as time, resources, rules, social norms, and physical realities. This means that when we choose to do one thing, we may be unable to do something else. Opportunity cost is the practice of considering or calculating the value of the things that we can’t do as a result of each potential decision.
For example, if you decide to spend an hour working on a freelance project, the opportunity cost of that decision is the value of the next best alternative activity that could have been pursued in that time, such as spending time with family or engaging in leisure activities. Understanding opportunity cost is important for making informed decisions and maximizing the value of available resources. The following are illustrative examples.
Risk vs Reward
An investor decides that the market is overvalued and goes completely to cash. This dramatically reduces their risk at the opportunity cost of the potential returns of being invested.
Education vs Work
A student considers the cost of a four year university education by calculating total tuition and expenses for the period. They may also include the opportunity cost of missing four years of salary in their calculations.
Product vs Product
A factory can produce 12,000 jars of peanut butter a day. The opportunity cost of every jar of smooth peanut butter is one jar of chunky peanut butter.
Service vs Service
A small airline has 28 aircraft. Their opportunity cost of offering a Tokyo to Hong Kong flight is the ability to offer a Tokyo to Taiwan flight.
Salary vs Quality of Life
An IT worker is offered a new job with a higher salary in a city with a lower quality of life. The opportunity cost of the higher salary is a lower quality of life such as reduced air quality.
Cost vs Quality
A manufacturer of headphones is facing stiff competition from low cost products with similar designs to their own. They decide to increase quality of their build to make the competition look and feel comparatively cheap. The opportunity cost of the new product design is increased cost and inability to compete on price.
Abilities vs Abilities
The opportunity cost of after school violin lessons at a particular school is the ability to join other after school activities such as baseball or the chess club.