Opportunity Cost

Simply stated, an opportunity cost is the cost of a missed opportunity. It is the opposite of the benefit that would have been gained had an action, not taken, been taken—the missed opportunity. This is a concept used in economics. Applied to a business decision, the opportunity cost might refer to the profit a company could have earned from its capital, equipment, and real estate if these assets had been used in a different way. The concept of opportunity cost may be applied to many different situations. It should be considered whenever circumstances are such that scarcity necessitates the election of one option over another. Opportunity cost is usually defined in terms of money, but it may also be considered in terms of time, person-hours, mechanical output, or any other finite resource.

Although opportunity costs are not generally considered by accountants—financial statements only include explicit costs, or actual outlays—they should be considered by managers. Most business owners do consider opportunity costs whenever they make a decision about which of two possible actions to take. Small businesses factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. For example, a landscaping firm may be bidding on two jobs each of which will use half of its equipment during a particular period of time. As a result, they will forgo other job opportunities some of which may be large and potentially profitable. Opportunity costs increase the cost of doing business, and thus should be recovered whenever possible as a portion of the overhead expense charged to every job.

EXAMPLES OF OPPORTUNITY COSTS

One way to demonstrate the concept of opportunity costs is through an example of investment capital. A private investor purchases $10,000 in a certain security, such as shares in a corporation, and after one year the investment has appreciated in value to $10,500. The investor's return is 5 percent. The investor considers other ways the $10,000 could have been invested, and discovers a bank certificate with an annual yield of 6 percent and a government bond that carries an annual yield of 7.5 percent. After a year, the bank certificate would have appreciated in value to $10,600, and the government bond would have appreciated to $10,750. The opportunity cost of purchasing shares is $100 relative to the bank certificate, and $250 relative to the government bond. The investor's decision to purchase shares with a 5 percent return comes at the cost of a lost opportunity to earn 6 or 7.5 percent.

Expressed in terms of time, consider a commuter who chooses to drive to work, rather than using public transportation. Because of heavy traffic and a lack of parking, it takes the commuter 90 minutes to get to work. If the same commute on public transportation would have taken only 40 minutes, the opportunity cost of driving would be 50 minutes. The commuter might naturally have chosen driving over public transportation because she had a use for the car after work or because she could not have anticipated traffic delays in driving. Experience can create a basis for future decisions, and the commuter may be less inclined to drive next time, knowing the consequences of traffic congestion.

In another example, a small business owns the building in which it operates, and thus pays no rent for office space. But this does not mean that the company's cost for office space is zero, even though an accountant might treat it that way. Instead, the small business owner must consider the opportunity cost associated with reserving the building for its current use. Perhaps the building could have been rented out to another company, with the business itself relocated to a location with a higher level of customer traffic. The foregone money from these alternative uses of the property is an opportunity cost of using the office space, and thus should be considered in calculations of the small business's expenses.

BIBLIOGRAPHY

Anderson, David Ray, Dennis J. Sweeney, and Thomas Arthur Williams. Statistics for Business and Economics. Thomson South-Western, 6 January 2004.

Blinder, Alan S., and William J. Baumol. Microeconomics: Principles and Policy. Thomson South-Western, June 2005.

Ernest, Robert Hall, and Marc Lieberman. Microeconomics. Thomson South-Western, 2004.

Vera-Munoz, Sandra C. "The Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in Resource Allocation Decisions." Accounting Review. January 1998.

                                Hillstrom, Northern Lights

                                 updated by Magee, ECDI

Opportunity Cost

An opportunity cost is defined as the value of a forgone activity or alternative when another item or activity is chosen. Opportunity cost comes into play in any decision that involves a tradeoff between two or more options. It is expressed as the relative cost of one alternative in terms of the next-best alternative. Opportunity cost is an important economic concept that finds application in a wide range of business decisions.

Opportunity costs are often overlooked in decision making. For example, to define the costs of a college education, a student would probably include such costs as tuition, housing, and books. These expenses are examples of accounting or monetary costs of college, but they by no means provide an all-inclusive list of costs. There are many opportunity costs that have been ignored: (1) wages that could have been earned during the time spent attending class, (2) the value of four years' job experience given up to go to school, (3) the value of any activities missed in order to allocate time to studying, and (4) the value of items that could have been purchased with tuition money or the interest the money could have earned over four years.

These opportunity costs may have significant value even though they may not have a specific monetary value. The decision maker must often subjectively estimate opportunity costs. If all options were purely financial, the value of all costs would be concrete, such as in the example of a mutual fund investment. If a person invests $10,000 in Mutual Fund ABC for one year, then he forgoes the returns that could have been made on that same $10,000 if it was placed in stock XYZ. If returns were expected to be 17 percent on the stock, then the investor has an opportunity cost of $1,700. The mutual fund may only expect returns of 10 percent ($1,000), so the difference between the two is $700.

This seems easy to evaluate, but what is actually the opportunity cost of placing the money into stock XYZ? The opportunity cost may also include the peace of mind for the investor in having his money invested in a professionally managed fund, compared to the sleep lost after watching his stock fall 15 percent in the first market correction while the mutual fund's losses were minimal. The values of these aspects of opportunity cost are not so easy to quantify. It should also be noted that an alternative is only an opportunity cost if it is a realistic option at that time. If it is not a feasible option, it is not an opportunity cost.

Opportunity-cost evaluation has many practical business applications, because opportunity costs will exist as long as resource scarcity exists. The value of the next-best alternative should be considered when choosing among production possibilities, calculating the cost of capital, analyzing comparative advantages, and even choosing which product to buy or how to spend time. According to Kroll, there are numerous real-world lessons about opportunity costs that managers should learn:

1. Even though they do not appear on a balance sheet or income statement, opportunity costs are real. By choosing between two courses of action, you assume the cost of the option not taken.
2. Since opportunity costs frequently relate to future events, they are often difficult to quantify.
3. Most people will overlook opportunity costs.

As most finance managers operate on a set budget with predetermined targets, many businesses easily pass over opportunities for growth. Most financial decisions are made without the consultation of operational managers. As a result, operational managers are often convinced by finance departments to avoid pursuing value-maximizing opportunities, assuming that the budget simply will not allow it. Instead, workers slave to achieve target production goals and avoid any changes that might hurt their short-term performance, for which they may be continually evaluated.

During the opening years of the twenty-first century, opportunity costs associated with more environmentally sensitive business practices and economic activity—such as combating carbon dioxide emissions through sequestration—came to the fore. Carbon sequestration (capture) is intended to reduce greenhouse gases in the atmosphere and can be achieved several different ways. One U.S. government study of different carbon capture strategies noted some of the opportunity costs. For example, one method of carbon sequestration involves afforestation, or planting trees in an area where there had been none before. Some opportunity costs associated with this type of carbon sequestration might include other profitable activities that could be conducted on that land. For example, the Congressional Budget Office noted that other measures to stop greenhouse gases might make growing crops for biofuels profitable. In this instance, there would be less incentive to devote land to trees for carbon sequestration because of the opportunity costs.

SEE ALSO Balance Sheets; Economics; Strategic Planning Failure

BIBLIOGRAPHY

Gamal, Atallah. “Opportunity Costs, Competition, and Firm Selection.” International Economic Journal 20, no. 4 (2006).

Gitz, Vincent, Jean-Charles Hourcade, and Philippe Ciais. “The timing of biological carbon sequestration and carbon abatement in the energy sector under optimal strategies against climate risks.” The Energy Journal 27, no.3 (2006): 113—133.

Internet Center for Management and Business Administration. “Opportunity Cost.” NetMBA.com. Available from: http://www.netmba.com/econ/micro/cost/opportunity.

Kroll, Karen. “Costly Omission.” Industry Week, 6 July 1998.

———“Opportunities Lost Because ‘There Isn't the Budget’?” Management Accounting, June 1998.

Sikora, Martin. “Trying to Recoup the Cost of Lost Opportunities.” Mergers and Acquisitions Journal, March 2000.

The U.S. Congressional Budget Office. “The Potential for Carbon Sequestration in the United States.” A CBO Paper. Washington, 2007. Available from: http://www.cbo.gov/.

Opportunity Cost

BIBLIOGRAPHY

The opportunity cost of an economic decision is the value or benefit of the next best alternative to that decision. For example, if a community decides to use part of its budget to reduce classroom size in schools, it cannot use that same money to achieve another priority, such as improving the aesthetics of the downtown area. Meeting concerns of parents and having better educated residents has clear benefits, but the opportunity cost is a more pleasing downtown drawing in tourism or new business. In opting for the former, the town must sacrifice the latter, at least until the town budget expands and there are more resources to accomplish alternative goals.

The concept of opportunity cost is a core element in the field of economics, particularly within the marginal theory of value, where economic decisions are based on maximizing benefits subject to resource constraints. Consumers are said to “maximize utility,” choosing the combination of goods that leads to the highest amount of satisfaction possible. However, the choices are limited by the consumer’s budget, and the consumer must choose a combination available within the budget constraints that exist. If the consumer wishes to see another movie, two chocolate bars must be given up. The benefit or pleasure obtained from eating the two chocolate bars is the opportunity cost of going to another movie. Similarly, workers are assumed to maximize utility, choosing a mix of income from labor and enjoyment from leisure time that best meets their individual desires, given time constraints. Firms maximize profits by selecting what to produce, how much to produce, and how to produce, subject to resource constraints.

Whole societies also face trade-offs. Existing amounts of land, labor, and other resources, as well as the current state of technology, limit how much can be produced and therefore consumed. If the society chooses to produce and consume more of one good, it must trade off some amount of another good. The opportunity cost of having more of one good is the benefit of consuming the alternative.

Opportunity costs are different from accounting costs, for which only price is considered. A student may view the cost of attending school as the monetary value of tuition and fees, but the tuition and fees are the accounting costs. The opportunity costs include the loss of income and experience of full-time employment, as well as the benefit of other items the tuition and fees could have bought. However, if the parents of the student decide to support her studies by paying her the income she would have earned in full-time employment, the forgone income is no longer an opportunity cost for the student. Instead, the parents may have sacrificed a world tour or a new boat in order to support their child, essentially assuming at least part of the opportunity costs unto themselves.

Opportunity costs include both private and social costs, but individual and collective decisions may not necessarily reflect the social costs. For example, if a firm chooses to invest in a new product line rather than expand its existing line, it is basing its decision on which choice will bring in the most profits given the costs of inputs. If manufacturing the new product results in more air pollution, social costs exist that are born by the larger community. These costs, which may include additional spending on health care and pollution mitigation, are opportunity costs of the firm’s decision, even if the firm did not consider them or pay them. The calculation of an opportunity cost is not the sum of all alternatives. If the consumer is watching more movies but eating less chocolate, the opportunity cost is only the pleasure that would have been derived from the chocolate, not the chocolate and the licorice and the popcorn, or any other choice that was not considered. Also, if something is not an option, it cannot be an opportunity cost. If the consumer wants to buy some hunting land that is not for sale, the hunting land cannot be the opportunity cost of deciding to buy a new car.

The concept of opportunity cost is frequently used in public policy debates. A favorite textbook expression of this is the “guns versus butter” debate. A society can choose more guns (i.e., more military spending), but in the context of limited resources, it must give up butter (i.e., spending on meeting human needs). During the military build-up and wars of the George W. Bush administration, many argued that the additional military spending had large opportunity costs. The money could have been used, for example, to provide health care for the uninsured, invest in greater energy efficiency, or a number of other alternatives. The opportunity cost of the spending is the benefit that could have been achieved from the most valued of these alternatives.

SEE ALSO Choice in Economics; Choice in Psychology; Economics; Marginalism; Microeconomics; Social Cost; Trade-offs; Utility, Objective; Utility, Subjective

BIBLIOGRAPHY

Goodwin, Neva, Julie A. Nelson, and Jonathan Harris. 2006. Macroeconomics in Context. Boston: Houghton Mifflin.

Riddell, Tom, Jean Schackleford, Steve Stamos, and Geoffrey Schneider. 2005. Economics: A Tool for Critically Understanding Society. 7th ed. Boston: Pearson Addison Wesley.

Anita Dancs

OPPORTUNITY COST

One of the lamentable facts of life is that nobody can have everything that he or she wants. This is due, in part, to scarce resources. Whether a teenager with a part-time job or a wealthy businessperson, no single person owns all of the money in the world. Furthermore, there are only twenty-four hours in a day, and seven days in a week. Time and money are only two of the many resources that are scarce in day-to-day living.

Unfortunately, because of these limits, individuals have to make choices in using scarce resources. One can use his or her time to work, play, sleep, or pursue other options or, one can select some combination of possible activities. People cannot spend twenty-four hours a day working, twenty-four hours a day playing, and twenty-four hours a day sleeping. People can choose to spend their salary on a nice house, an expensive vacation, or on a yacht, but they probably cannot afford all three. They must make choices with their limited resources of money.

In making choices for using limited resources, it is reasonable to evaluate the costs and benefits of all possible options. For instance, suppose one has been trying to decide how to spend the next few years of one's life. He or she has narrowed the options down to two: (1) working at a full-time job, or (2) becoming a full-time student. Going to school will cost approximately $12,000 per year in tuition, books, and room and board at the local state university for the next four years. In addition, he or she will forego the salary of a full-time job, which is $24,000 per year. This makes the total cost of going to school $36,000 per year. In return he or she gets the pleasure, social interaction, and personal fulfillment associated with gaining an education, as well as the expectation of an increase in salary through the remainder of his or her work life.

The question that must be answer is, "Do the benefits of education outweigh the costs?" If they do, school should be selected. If the costs are greater than the benefits, the full-time job should be kept.

An "opportunity cost" is the value of the next-best alternative. That is, it is the value of the option that was not selected. In the example, if the person had chosen to keep the job, then the opportunity cost is the benefit of going to school, including the intangible benefits of pleasure, social interaction, and personal fulfillment as well as the tangible benefit of an increased future salary for the person's remaining working life. If the person had chosen to go to school, then the opportunity cost is the $24,000 per year that would have been earned at the full-time job.

One way of visualizing this concept is through the use of a production possibilities curve—a graph that relates the tradeoff between two possible choices, or some combination of the possibilities. Consider a very simple possible economy for a country. This country can produce two goods: guns (i.e., defense) or butter (i.e., consumer goods). If this country has historically used all of its resources to produce guns then it may be willing to consider allocating some of its resources to the production of butter. Initially, the resources that are least effective in producing guns (e.g., farmland) will be reallocated to the production of butter. Thus, the country does not forfeit many guns to produce a relatively large amount of butter. However, as the country reallocates more resources to the production of butter it is decreasingly productive. At the extreme, when the country gives up the last of its production of guns, the resource is very good for producing guns and not very useful in the production of butter (e.g., a high-tech armaments production facility). Figure 1 demonstrates this situation graphically in showing an example of the production possibilities curve.

In Figure 1, everything on the curved line or in the gray area is a possible production combination of guns and butter in the simple economy. Any combination on the line uses all of the available resources, while any combination in the gray area is considered inefficient since it does not use all of the available resources. Any combination in the white area is impossible to achieve, given the country's resource limitations.

The idea that the country will initially reallocate its least productive resource to the production of the other good is known as the law of increasing opportunity cost. Thus, if the production of the initial ton of butter costs five hundred guns, then the next ton of butter, which uses resources that are better at producing guns, will cost more guns. The next ton of butter will cost still more guns, and so on. This is represented in Figure 1 by the changing slope of the production possibilities curve.

SUMMARY

Because resources are limited, choices must be made. When evaluating choices in this decision-making process, one attempts to select the best option. That is, one selects the option that offers the most benefit for the costs incurred, and which are possible given any constraints. This is true for individuals, businesses, or countries, though the decisions that each entity makes are vastly different. The second best option is called the opportunity cost and is what is given up when decisions are made.

see also Costs

Denise Woodberry

OPPORTUNITY COST

An opportunity cost is a way of analyzing an economic decision to determine its real cost. For an accountant or for a consumer in the grocery store the cost of an item is the amount actually paid for the item—that is, its price. In economics, however, determining the real cost of an item or of an economic decision means taking into account the alternative uses that could be made of one's money. For example, a manager making $40,000 a year is considering whether the increase in salary she will get by earning a law degree will justify the cost of tuition, housing, and all her other living expenses at school. In making her decision, however, she must also include the $40,000 in salary per year she will not be able to earn while attending school. The lost salary together with the costs of tuition and living expenses is the real cost—the opportunity cost—of her law school decision. Similarly, suppose someone invests $10,000 in a stock that falls in value over a six-month period and then sells the stock as soon as it climbs back to the price he initially paid. The investor may feel like congratulating himself for being patient enough to wait until the stock regained its initial price before selling; after all, he "broke even." In reality, however, since the investor could have invested the $10,000 in a stock that grew 20 percent over that same six-month period, he did not in fact "break even"—he incurred an opportunity cost of $2,000.

The idea of opportunity costs was first defined by the neoclassicist economists of the nineteenth century, and today it finds application in the economic decision making of individual consumers, companies, and entire economies. In evaluating whether to make a particular investment, for example, a company will first determine what use of its available capital will provide the best return. For various reasons, the company may in the end decide not to invest its money in the option that offers the lowest opportunity cost. However, it will always know what the opportunity cost of each of its options is and whether that cost is growing or decreasing. The expression "There's no such thing as a free lunch," popularized by American economist Milton Friedman (1912–), is another way of saying that every economic decision has hidden opportunity costs that must be taken into account to put money to its best use.

See also: Milton Friedman, Price

there's no such thing as a free lunch.

milton friedman, economist