Understanding Opportunity Cost: The Value of Choice

Understanding Opportunity Cost: The Value of Choice

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Rashmi
Rashmi Karan
Manager - Content
Updated on Dec 14, 2023 11:41 IST

When you have a company or business, decision-making becomes an everyday thing. Each one implies a series of alternatives between which you have to decide. Therefore, it is important to study your options and identify the gains and losses that each one represents. In the business world, this is known as opportunity cost, and it is a fundamental calculation that involves assessing aspects such as costs, production and investment. In this blog, we will show you how to analyze the opportunity costs so that you do not neglect the best option for your business and thus make your investment as profitable as possible.

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What is Opportunity Cost?

Opportunity cost is an economic metric that helps evaluate the consequences of any choice made and represents the cost of not choosing the next best alternative when making a decision. It can be applied in any field: managing the global economy, business and daily life. With the opportunity cost, you can decide which option is better and monitor the company’s efficiency.

When making decisions, there are always several options. In the simplest case, it is about carrying out any activity or leaving everything as it is. When a decision is made, other options are abandoned. The value of this decision is determined by what had to be sacrificed or rejected in making a decision.

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Friedrich von Wieser, an Austrian sociologist and economist, first coined the term alternative or opportunity cost in his Theory of Social Economy in 1914. 

von Wieser defines opportunity cost as what we give up when we make an economic decision. According to his theory, the opportunity cost only makes sense when only one action or investment alternative can be chosen among several simultaneous or consecutive options forcing us to discard the remaining options.

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Types of Opportunity Costs

There are two main types of opportunity costs:

  1. Explicit Opportunity Cost: Explicit Opportunity Cost is the actual monetary costs of a decision, such as the cost of tuition for attending college or of purchasing a new piece of equipment for a business.
  2. Implicit Opportunity Cost: This refers to the opportunity costs not reflected in monetary terms, such as the value of the time or resources that could have been used for an alternative purpose. For example, the time spent attending college could have been used to work and earn money, or the resources invested in a new piece of equipment could have been used for research and development instead.
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Steps To Calculate The Opportunity Cost

You can estimate the opportunity cost by following these guidelines:

  1. Identify the options: What do you want? The answer to this question is the first thing you must be clear about. The alternatives that you have will be valid as long as you can extract an economic benefit from them.
  2. Determine the value: Assign a value to each option. This can be in monetary terms, time, or any other unit of measurement appropriate for the situation. 

For example, going to college might cost $50,000 per year, while starting a business might require an initial investment of $100,000.

  1. Calculate each alternative’s expenses: Everything implies an outflow of money that must be quantified.
  2. Calculate the return on investment: Just as you calculated the expenses, you must calculate the benefits.  
  3. Choose the option that gives you the most benefit: Time to make the decision. Choose the alternative that has the highest ROI.
  4. Calculate Opportunity Costs: Now, you have to compare ROI values. Subtract the value of the alternative from the value of the chosen option. For example, if going to college costs $50,000 per year and starting a business requires an initial investment of $100,000, the opportunity cost of going to college instead of starting a business is $150,000

Here are some tips to help you calculate the opportunity costs –

Steps To Calculate The Opportunity Cost

Example of Opportunity Costs

To illustrate the concept of opportunity costs, suppose that a person has two job offers with the following conditions:

  • Offer A: Salary Rs. 15,00,000
  • Offer B: Salary Rs. 14,00,000.

It is clear that if I choose B, I am giving up Rs. 1,00,000, which will be the opportunity cost of option B.

But there are cases in which it is more complex to determine the opportunity cost, such as:

  • Offer A: Salary Rs. 20,00,000.
  • Offer B: Salary Rs. 15,00,000 + commissions.

With offer A, a salary of Rs. 20,00,000 annually is guaranteed, but with offer B, you can obtain a salary of Rs. 30,00,000. Still, the amount is uncertain, and there will be times when you may only earn the basic salary of Rs. 15,00,000 only. 

What do you do in such a case? The answer to this question is whether you want a stable income or are willing to take risks. 

It is like the taxpayer who weighs paying tax or evading it. If you pay, you don’t save money, but if you don’t, you save money in the present, and you risk ending up paying more in the future for penalties and interest.

Everyday life involves decisions involving opportunity costs incurred; we don’t realize it or consider it.


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FAQs

How to define opportunity cost?

The opportunity cost in finance is also known as the alternative cost or value of the best option not selected. It is the number of resources we stop receiving when deciding between two or more options.

How important is the opportunity cost in everyday life?

The opportunity cost is very important in decision-making since it makes you see the real cost of your decision, including what you give up, something that is very easy to overlook if you have yet to internalize this concept.

How does the opportunity cost work in finance?

The opportunity cost is directly related to the valuation of the investment. On the one hand, with the risk that is run and on the other hand, with the unanalyzed profitability that could be obtained in another business.

How to minimize the opportunity cost?

Opportunity costs can be minimized by carefully considering all available alternatives and evaluating their benefits and drawbacks. It is important to weigh the costs and benefits of each option and choose the one that provides the greatest net benefit, considering the opportunity cost of each alternative.

What if the opportunity cost is negative?

If the opportunity cost is negative, it means that the alternative option being foregone to pursue a particular choice is more costly than the chosen option. This would suggest that the chosen option is more beneficial than the alternative.

About the Author
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Rashmi Karan
Manager - Content

Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio