Opportunity Cost
What is Opportunity Cost?
Opportunity cost is the value of the next-best alternative you give up when you make a choice.
Because resources are scarce, every choice means forgoing something else, and economists count only the next-best forgone option. Opportunity cost includes both explicit costs (money paid) and implicit costs (forgone earnings or benefits). This is why economic cost can be larger than simple accounting cost.
Opportunity Cost: a worked example
An accountant earning $60,000 a year quits to open her own firm. In the first year the firm takes in $200,000 of revenue against $150,000 of explicit costs, so her accountant reports a $50,000 profit. Economists also charge the $60,000 salary she gave up, an implicit cost, which makes economic profit 200,000 minus 150,000 minus 60,000, or negative $10,000. She is $10,000 worse off than if she had stayed employed, even though the books show a profit.
The mistake students make with opportunity cost
Students total up every option they turned down. Opportunity cost counts only the single next-best alternative, not the sum of all rejected ones. If a Saturday could be spent working for $120, at a concert worth $90, or on a hike worth $40, then choosing to work has an opportunity cost of $90, not $130.
Opportunity Cost questions
Is opportunity cost always measured in money?
Opportunity cost is not always money; it is the value of the next-best alternative given up, which may be time, enjoyment, sleep or any other benefit. Money is simply a convenient yardstick when the forgone alternative happens to carry a price.
What is the difference between explicit and implicit costs?
Explicit costs are payments a firm actually makes to outsiders, such as wages, rent and supplies, while implicit costs are the value of resources the owner already owns and gives up by using them in the business, such as a forgone salary. Full opportunity cost includes both, which is why economic profit is smaller than accounting profit.
Do sunk costs count in opportunity cost?
Sunk costs do not count in opportunity cost, because money already spent and unrecoverable cannot be regained by any choice available now. Only the next-best alternative you can still choose belongs in the calculation.
Formula / Example
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Related terms
The same idea in another course
Opportunity cost applied to moneyThe same idea with a dollar figure attached, which is what makes an interest rate a cost of holding cash. On FinanceLearn, a sister site.
Common comparisons
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