What is Opportunity Cost?

Economic decisions involve choosing between economic alternatives. Indeed, what is economics but an attempt to strike harmony between scarcity and choice? Scarce resources mean that you cannot have everything - you always have to consider your priorities and decide upon one alternative. Often, while we figure out exactly what we want, we also keep in mind the next best alternative in case we don't get a utility that exactly matches our current requirements or expectations. This is done as a kind of backup to fall upon in two possible cases - either the main utility having exact number of desired characteristics is not available or the prospective consumer is unable to afford it. In such a case, the next best alternative is considered. So, what is opportunity cost? It is the cost of this next best alternative. Now, let's get a closer look at this component of economic cost.

What are Opportunity Costs?

Let's start with a situational example. Say, you're out to buy red wine for serving at that party at your place in the evening. You would prefer a relatively softer textured wine than the staple Cabernet Sauvignon or Shiraz. Therefore, your first choice would be Merlot. However, if you don't get good Merlot in your neighborhood wine store, you would not mind settling for a good brand of Pinot noir. Therefore, the opportunity cost to be considered, in this case, would be the cost that you would have to incur in procuring the second best alternative, Pinot noir in this case. Also, the opportunity cost of the Pinot noir bottle would be a bottle of Merlot, which you gave up on in favor of the former.

Therefore, opportunity cost is the cost related to acquiring the next best alternative from among several mutually exclusive choices, being the economic option in the form of goods or utilities. The concept of opportunity cost also applies to mutually exclusive economic decisions, involving the same amount of financial consideration, other than goods and services. The concept of opportunity cost has very significant bearings on investment decisions. In fact, financial investment decisions provide some of the most lucid opportunity cost examples. Here's one:

Aron has $15, 000 which he wishes to invest in order to earn financial returns. He has two options for investment - he can either buy shares of XYZ Ltd. or he can deposit the entire amount in a bank account and earn interest on it. It he decides to buy the stock, then the opportunity cost for those stocks is the value of bank interest that he is ready to forgo in favor of investing in stock. On the other hand, if he decides to deposit the entire amount in the bank account, the opportunity cost for this investment would be the amount of dividend earnings that he is giving up in order to earn interest.

How to Calculate Opportunity Cost

Now that you have a fair idea of what opportunity cost is, you must be wondering how to calculate opportunity cost. Well the opportunity cost figure is nothing but the differential value between the values of the selected alternative and the next best alternative. Here's how you go about it:

Opportunity Cost = Cost of Selected Alternative Cost of Next Best Alternative

The following example would clear it for you.

Shane has three choices after leaving graduate school. He can either accept the corporate job offer that would pay him $75, 000 a year, he can accept the position of a gym instructor at his neighborhood fitness center which would pay him $38, 000 a year or he can go for higher studies which would cost him $ 32, 000 a year. Shane opts for higher studies. What would his opportunity cost be?

Number of Mutually Exclusive alternatives = 3
Value of Chosen Alternative = 32, 000
Value of Next Best Alternative = 75, 000
Therefore, Opportunity Cost = Cost of Selected Alternative - Cost of Next Best Alternative
i.e., Opportunity Cost = 32, 000 75, 000 = 43, 000

Hence, his decision for higher studies will not only cost him the actual fees for such studies but also the value of the next best alternative that he gives up.

I guess, that should be able to explain opportunity cost in simple and lucid terms. I hope I have been able to resolve your doubts regarding this concept of economics successfully. Do feel free to ask questions regarding any part that was not clear to you. I would be more than glad to help. With that, I wish you luck with economics!