The opportunity cost of an action is the value of the best alternative that is forgone when the action is taken. In other words, it is the cost of what you give up in order to do something else.
For example, let’s say you have to decide whether to go to the movies or stay home and study. The opportunity cost of going to the movies is the value of the studying that you would have done if you had stayed home. If you would have gotten an A on your test if you had stayed home to study, then the opportunity cost of going to the movies is the value of an A.
In some cases, the opportunity cost of an action can be difficult to measure. For example, let’s say you have to decide whether to take a new job that pays more money but requires you to work longer hours. The opportunity cost of taking the new job is the value of your free time that you would have had if you had stayed at your old job. It is difficult to put a monetary value on free time, so the opportunity cost of taking the new job is not always easy to determine.
The opportunity cost of an action is an important concept to understand, because it can help you make better decisions. When you are faced with a choice, it is important to consider the opportunity cost of each option. By doing so, you can make sure that you are making the decision that is best for you.
Opportunity cost vs. sunk cost
A sunk cost is money already spent that cannot be recovered. An opportunity cost is the potential return that could have been earned on an investment but was lost because the money was invested elsewhere.
- You buy 1,000 shares of company A at $10 per share. This is a sunk cost of $10,000.
- Company B is a similar company, but it is trading at $10 per share.
- You decide to invest your $10,000 in company A instead of company B.
One year later, company A is trading at $12 per share, and company B is trading at $15 per share. You have made a profit of $2,000 on your investment in company A. However, you could have made a profit of $5,000 if you had invested your money in company B. The difference of $3,000 is the opportunity cost of choosing company A over company B.
Opportunity costs are important to consider when making investment decisions. By understanding opportunity costs, you can make better decisions about how to allocate your resources.
Opportunity cost and risk
Risk is the possibility of losing money on an investment. Opportunity cost is the potential return that could have been earned on an investment but was lost because the money was invested elsewhere.
Risk and opportunity cost are related, but they are not the same thing. Risk is a measure of the potential downside of an investment, while opportunity cost is a measure of the potential upside of a forgone investment.
- Investment A is risky but has an ROI of 25%.
- Investment B is far less risky but only has an ROI of 5%.
Even though investment A is more risky, it has the potential to generate a higher return. Therefore, the opportunity cost of choosing investment B over investment A is higher.
However, it is important to note that risk and opportunity cost are not the only factors to consider when making investment decisions. Other factors, such as your investment goals and risk tolerance, should also be considered.
Here are some additional things to keep in mind about opportunity cost:
- Opportunity cost is always subjective. The value of the forgone alternative will vary from person to person.
- Opportunity cost can be both monetary and non-monetary. The monetary cost of an action is easy to measure, but the non-monetary cost can be more difficult to quantify.
- Opportunity cost can be negative or positive. The opportunity cost of an action is negative if the forgone alternative is more valuable than the action that is taken. The opportunity cost of an action is positive if the forgone alternative is less valuable than the action that is taken.
Here are some examples of opportunity cost in everyday life:
- When you decide to go to college, you are giving up the opportunity to work full-time and earn money.
- When you decide to buy a new car, you are giving up the opportunity to save money or invest in other things.
- When you decide to start a business, you are giving up the opportunity to have a stable job with a steady income.
Opportunity cost is a powerful tool that can help you make better decisions. By understanding the opportunity cost of each option, you can make sure that you are making the decision that is best for you.
Here are some tips for considering opportunity cost when making decisions:
- Identify all of the options available to you.
- Consider the costs and benefits of each option.
- Estimate the opportunity cost of each option.
- Choose the option that has the highest net benefit.
It’s important to remember that opportunity cost is always changing. As your circumstances change, so too will the opportunity cost of your choices. That’s why it’s important to revisit your decisions regularly and make sure you’re still making the best choices for you.
Opportunity cost can be a powerful tool for making better decisions. By understanding and considering opportunity cost, you can make choices that align with your goals and values.