Opportunity Cost

If an investor has alternative projects but has a limited resources one or some of them have to preferred over the others. In such cases the cost of difference between preferred  investment(s) and the one(s) that have been given up is called opportunity cost.

For example you invest in a stock and it returns 4% over the year. In placing your money in the stock, you gave up the opportunity of another investment - for example, a risk-free government bond yielding 6%. In this case, your opportunity cost is 2% (6% - 4%).

Opportunity cost can be applied on any decision that has alternatives put this in another way; any decision that involves a choice between two or more options has an opportunity cost. Following example is most common one, given to explain opportunity cost in areas other than finance.

If you are working and having a steady stream of salary and decide to go to a university by having a break in your career, then you must give up your earnings for a certain period and pay your study fees. The rational behind such a decision can be the offset of higher salary you are projecting by having a better degree.

Consider the case of an MBA student who pays £16,000 per year in tuition and fees at a university. For a two-year program, the cost of tuition and fees would be £32,000. This is the monetary cost of the education. However, when making the decision to go back to school, opportunity cost, which includes the income that the student would have earned if the alternative decision of remaining in his or her job had been made. If the student had been earning £35,000 per year £70,000 in salary would be given up Adding this amount to the educational chargers results in a cost of $102,000 for such a degree.

As another example, if a shipwrecked sailor on a desert island is capable of catching 10 fish or harvesting 5 coconuts in one day, then the opportunity cost of producing one coconut is two fish (10 fish / 5 coconuts). Note that this simple example assumes that the production possibility frontier between fish and coconuts is linear.

Relative Price

Opportunity cost is expressed in relative price, that is, the price of one choice relative to the price of another.

For example, if milk costs $4 per gallon and bread costs $2 per loaf, then the relative price of milk is 2 loaves of bread. If a consumer goes to the grocery store with only $4 and buys a gallon of milk with it, then one can say that the opportunity cost of that gallon of milk was 2 loaves of bread (assuming that bread was the next best alternative).

In many cases, the relative price provides better insight into the real cost of a good than does the monetary price.

Applications of Opportunity Cost

The concept of opportunity cost has a wide range of applications including:

  • Consumer choice
  • Production possibilities
  • Cost of capital
  • Time management
  • Career choice
  • Analysis of comparative advantage

Assessing opportunity costs is fundamental to assessing the actual cost of any course of action. In the case where there is no explicit accounting or monetary cost for a certain course of action, overlooking opportunity costs may produce the impression that it costs nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.

The other important point is that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best one among the others. The opportunity cost of the city's decision to build the hospital on its available land is the loss of the land for a sporting center, or the inability to use the land for a parking area, or the money which could have been earned from selling the land, or the loss of any of any other possibilities. But certainly not all of these in aggregate, because the land cannot be used for more than one purposes at a time.

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