What is opportunity cost?
Opportunity cost is an important idea in economics that many businesses think about when investing. It is a crucial concept to think about when choosing to invest in something. So what does opportunity cost mean? Opportunity cost represents the possible benefits that a person or business misses out on when choosing one thing over another. When an investor has multiple choices in front of them, they use the concept of opportunity cost to help them estimate which option leads to more benefits.
Opportunity cost formula
Opportunity Cost = Return on the Best Option not Chosen – Return on the Option Chosen
How to use the formula
The formula is used to calculate how much money you could have gained in an investment. Let us say for example you bought a house for $500,000 and in the next 10 years the price of the house went up to $800,000. Let us call the house you bought house A. Now let’s say there was another house in the area you could have bought for $300,000 that went up to $700,000 in 10 years also. Let us call that house B. The return on the house you bought was $300,000, and the return on the house you could have bought was $400,000. House B – House A = $100,000. In this case, we would have been better off buying house B. We lost out on a potential additional $100,000 of profit. As this example illustrates, a negative number in the formula indicates lost opportunity cost.
Opportunity cost examples
- If you were to spend $8 on pizza everyday at lunch, you could have instead used your eight dollars on a healthier option, a meal that gives you more for your money, or even a meal that tastes better than pizza.
- If you were to spend $10 on school folders that were 50 cents each, you could have instead spent $10 on folders that were 25 cents each.
- If you were to give a company $400 to fix the heater in your house, you could have instead used that money, to buy a backsplash for your kitchen.
- If you were to spend $38,000 on a lot with 0.27 acres of land, you could have instead spent $30,000 on a lot with 0.30 acres of land nearby.
How to use opportunity cost
To use opportunity cost, you have to remember to use it right. Make sure to note all of the benefits and costs for each available option and weigh them against each other. In addition, the best way to calculate opportunity costs is to have real and accurate numbers to work with because using estimates won’t nearly help as much. Secondly, think about the future when calculating opportunity cost. For example, if you are deciding to invest between two properties, think about which property will most likely be worth more in the years to come. Don’t just think about short-term profit. One property might make you more money in 2 years than the other. But in 10 years the property you didn’t invest into could have made you more money than the first property ever could.
Lastly, opportunity cost does not have to be used solely for investing. It can also be used in other situations. Let’s say that you decide to quit school so you can get a job and start making money. But the opportunity cost of this decision is the money you could have made if you continued school. If you decided to do this, opportunities could have arisen for higher paying jobs.