Importance and Working of Opportunity Cost

Introduction: What is Opportunity Cost?

Investors usually have more than one investment option but have to choose only one while leaving all other options. In this process, the investor has to lose the gain of the next best alternative. This potential loss an investor faces or the gain that is missed out for choosing one alternative to the next best one is known as the opportunity cost.

Therefore, we may say that the value lost while choosing one option leaving the next best one is the opportunity cost. Investors choose an investment option thinking that it will provide the best returns to them. In this process, they have to forego the returns of the next best alternative investment. Therefore, it is obvious that the investment option one chooses will either have a profit or loss. This potential profit or loss is the outcome of the opportunity cost.

Therefore, we see that we may use another definition for opportunity cost. It is the loss an investor makes while choosing one investment option instead of another one. The opportunity cost is the loss an investor makes for one gain or loss of one gain over another.

Comparative Analysis

1 month's production

Product	Country A	Country B
Tea	100 Tones	30 Tones
Wool	20 Tones	100 Tonnes

Opportunity cost

Product	Country A	Country B
1 Tonne of Tea	Opportunity cost = wool/tea = 100/20 = 0.2 Tonne of Wool	Opportunity cost = wool/tea = 100/30 = 3.3 Tones of Wool
1 Tonne of Wool	Opportunity cost = tea/wool = 20/100 = 5 Tonnes of Tea	Opportunity cost = tea/wool = 30/100 = 0.3 Tonnes of Tea

Examples of Opportunity Cost

One simple example of opportunity cost can be found in the case of selling or holding shares of a company. While an investor may hold the stocks or sell them to avail potential gains, they will consider the option of potential gain of holding stocks in the future. If they sell the stocks, the loss they make by not holding the stocks for a certain period of the future is the opportunity cost.

Opportunity cost does not always have to be in the field of economy. It can also be part of simple life decisions. For example, you may wish to weigh the pros and cons of not going to college. What are the outcomes of missing college and choosing to find a job? Such decisions will always weigh the opportunity cost of the chosen decision over the one not availed.

How Opportunity Cost Works

While making a financial decision, one may try to determine the returns obtained from each option.

For example, one may think to sell the stocks he currently has to buy some other stock at a slightly lower rate. The opportunities in such a case could be visualized using the following table.

Current Stock A	New Stock B
The future value may rise	The future value may rise
The future value may go down	The future value may go down

Let’s say that the current stock has a value of Rs 20,000 while stock B has a rate of Rs 40,000. So, you spend an extra 20,000 to buy a stock. In such a case the potential future scenarios should be weighed.

The cost of B is more than the cost of A but B can still offer more gains because a little lower interest rate on more money can still provide more returns. However, one must make more returns than what he does in the case of Rs 20,000, the amount that was invested extra so that value may be added to stock B.

In this example, the opportunity cost is the continued interest that can be earned on Stock A, and the primary loss of Rs 20,000 on Stock B while intending to recover it and grow the profits in the future.

Calculating Opportunity Cost

Opportunity cost is usually not an exact financial measure but it can be used to determine what someone loses by choosing one option and leaving the other one by not availing it.

The formula for determining the opportunity cost is

$$\mathrm{Opportunity\:Cost\:=\:𝐅𝐎\:−\:𝐂𝐎}$$

Where, FO = Return on Best foregone option

CO= Return on the chosen option.

In general, opportunity cost is a common concept investors and economists want to explore. For example, what would have happened if Tesla was not established? There might have been some other company that used the electric car concept to be equally successful or one might have never heard of Elon Musk.

Types of Opportunity Costs

There are two types of opportunity costs, namely, Explicit and Implicit.

Explicit costs

Explicit costs are direct, financial costs that are made out of pocket. It generally consists of monetary expenditure. Foir example, suppose you add a new flavor of ice cream to your restaurant menu that costs Rs 100. So, your explicit cost is Rs 100. The opportunity cost is what else could have been done if it was not used as a new item on the menu. It could have been given to charity or you could have to spend it for yourself to buy items you need.

Implicit costs

Implicit costs are not direct, or financial in nature. Rather, they represent resources through which an income could be generated. For example, you could rent your idle firm house which is not in use to someone else. The implicit cost is the rental income you generate from the lease. In this case, you are giving up the opportunity to generate income from the farmhouse if you do not use it. However, the use of the farmhouse does not cost anything to you if you choose to use it. So, here the opportunity cost is your idea not to use the home but rent it to someone else to gain an income.

Importance of Opportunity Cost

The opportunity cost is the measure of the cost of alternatives and provides an idea of gains from short-term sacrifices. It can provide you with an idea of the potential of an opportunity. It also helps in making better decisions and in the longer term, it offers potential profits that cannot be availed by any other resource. Opportunity cost also tells whether a project is viable for profit or not, so, by using it, one can measure the real profits before it is obtained.

Conclusion

Opportunity cost is very important because it helps in making an informed and better decision. It does not always have to be in the field of finance or economics, opportunity cost is a useful idea in daily life too. It is so because every decision we make in life has an opportunity cost. Therefore, having an idea of how to determine it can lead to a more successful and rewarding life.

FAQs

Qns 1. What is meant by opportunity cost to investors?

Ans. The potential loss an investor faces or the gain that is missed out for choosing one alternative to the next best one is known as the opportunity cost.

Qns 2. How many types of opportunity costs are there?

Ans. There are two types of opportunity costs. The explicit costs are direct and strictly financial in nature while the implicit costs are non-financial in general.

Qns 3. What is the formula for determining the opportunity cost?

Ans. The formula for determining the opportunity cost is

$\mathrm{Opportunity\:Cost\:=\:𝐅𝐎\:−\:𝐂𝐎}$

Where, FO = Return on Best foregone option CO= Return on the chosen option.