What is opportunity cost?
Imagine you’re deciding between purchasing a new SUV and an old sedan. When weighing the two options, you’d probably think about what you’d get for your money with each car, and what you may miss out on by choosing the SUV versus the sedan, for example your savings.
This idea is called opportunity cost, and it can help people and businesses make better financial choices. Opportunity cost is a term economists use to describe the relationship between what an item adds to your life, and how much it might cost you by not having it, taking into account your other options. So the opportunity cost of buying an SUV includes an alternative option, such as buying a less expensive sedan.
In short, opportunity cost can be described as the cost of something you didn’t choose.
There is no specifically defined or agreed on mathematical formula to calculate opportunity cost, but there are ways to think about opportunity costs in a mathematical way.
Opportunity cost is the value of the next best alternative or option. This value may or may not be measured in money. Value can also be measured by other means like time or satisfaction.
One formula to calculate opportunity costs could be the ratio of what you are sacrificing to what you are gaining. If we think about opportunity costs like this, then the formula is very straight forward.
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What you sacrifice / What you gain = opportunity costs
Businesses can also apply the concept of opportunity costs, but they tend to call it economic costs. For business, opportunity costs exist in the production process.
Opportunity costs in business may relate to not choosing opportunities, for example to produce alternative goods and services. When businesses think about opportunity costs they see them this way:
Total revenue-economic profit = opportunity costs
The key to understanding how businesses see opportunity costs is to understand the concept of economic profit. For businesses, economic profit is the amount of money made after deducting both explicit and implicit costs.
Explicit costs are the out-of-pocket expenses required to run the business. The idea of implicit costs is more abstract, but it is generally the value that could have been generated if the resources of the business had been used for other purposes.
This concept can be a bit complicated, but the general idea is that a business needs to earn revenue in excess of its opportunity costs for the benefits to accrue to the owners.
If a company is not able to earn an economic profit, it may fail. The owners of the business will eventually have to exit the industry, and the resources of the business will be put to a different use.
How to calculate opportunity cost
For most people, it makes most sense to think about opportunity costs from the perspective of ‘what do I sacrifice?’ versus ‘what do I gain?’
For example, you may have the choice between two jobs, a mechanic or a bartender.If you work as a mechanic, you could earn $50 per hour. If you work as a bartender, even with tips, your wage could be around $25 per hour.*
So what could you be giving up by working as a bartender versus working as a mechanic?
At first, in the example above, it may look like $25 per hour. But this is not the way opportunity costs are calculated. The formula is not “what I sacrifice minus what I gain.” Instead, it is necessary to look at the ratio of sacrifice to gain.
Going back to our example, if you chose to spend an hour working as a bartender instead of as a mechanic, then you are actually giving up ($50 mechanic / $25 bartender) = $2 of opportunity cost. This $2 says, for every dollar I earn working for one hour as a bartender, I sacrifice $2 working the same hour as a mechanic.
It is important to look at the ratio between two alternatives to correctly calculate opportunity costs.
Weighing opportunity cost when you invest
You can think about opportunity cost when you consider investing. Say you’re deciding between investing $50 in stocks or in bonds. If you decide to buy $50 worth of a stock, you might see the price increase and make money from your investment. (You might also see the price decrease, and lose money.) If you decide to buy a $50 bond, you can have a clearer picture of what you may earn on that investment, but in this hypothetical example you could have missed out on more dramatic increases in the stock price.*
In this case, you can consider an investment’s opportunity cost by weighing the potential pros and cons of investing in a bond, versus the pros and cons of investing in a stock.
Remember that all investing carries risk, and you can lose money in the market. Stash recommends diversifying when you invest, and following the Stash Way. A diversified portfolio can have a mix of stocks, bonds, and exchange-traded funds (ETFs).