What is Opportunity Cost?
What is Opportunity Cost
Opportunity cost is the second best alternative that must be given up when making an economic choice. In other words, it is the value of the best opportunity you had to give up because of the decision you made.
Opportunity cost, also called alternative cost, can simply be defined as the best option given up. The resources in the world are limited, so it is impossible to meet all needs. For this reason, individuals and companies tend to make the most beneficial and profitable decision in the use of scarce resources. In other words, they have to make rational choices.
Every economic choice made has an opportunity cost. Although opportunity cost is mostly defined as financial, these limited resources can be evaluated in terms of time or different units. The concept of opportunity cost or alternative cost allows individuals and companies to make optimal decisions by evaluating the benefits and costs of different options. However, it can also help in prioritizing resources and choosing alternatives that are compatible with your long-term goals.
How to Calculate Opportunity Cost?
The concept of opportunity cost or alternative cost provides the opportunity to evaluate the potential benefits and costs of choosing one option over another. In other words, the return of the chosen choice must be higher than the one given up, otherwise the cost increases.
Opportunity cost is calculated by subtracting the benefit (return) of the chosen option from the benefit (return) of the next best alternative. When making a rational decision, you may have more than one alternative, but the concept of opportunity cost only includes the next best alternative in the calculation. In other words, when a rational decision is made, only one option can be chosen, and therefore only one alternative is given up.
Opportunity Cost = Benefit of Next Best Alternative – Chosen
Benefit of the Option
When calculating opportunity cost, the decision must first be determined. At this point, the options and alternatives to be implemented should be defined. The potential benefits and costs of each option must then be evaluated. After evaluating the returns and costs, the next best alternative to the option to be implemented should be determined. On the other hand, the level of risk associated with the available options and the time frame in which the benefits and costs will be realized should also be taken into account. High-risk options may have higher opportunity costs because potential benefits may be uncertain or variable. Similarly, the time period for realizing benefits and costs may also affect the opportunity cost calculation. Finally, by comparing the benefits of the option to be implemented with the benefits of the next best alternative, the associated opportunity cost can be determined. To calculate this, the benefits of the chosen option need to be subtracted from the benefits of the next best alternative.
Opportunity cost means different things to each participant in the economy. Alternative cost concept; It refers to the opportunity cost in consumption decisions for the consumer, in investment decisions for the investor, in production decisions for the producer, and in public expenditures for the state. To give an example for each participant;
For the consumer; When a person buys any product or service for 100 TL, he/she gives up purchasing another product or service for the same amount. In this case, the opportunity cost of the product or service purchased is the value of other products or services that could be purchased. If a person spends an hour working, then he will not be able to do any other activity in that hour. In this case, the opportunity cost of working is the benefits that can be obtained from other activities that can be done at that time.
For investors; In the scenario where there is an option to invest in two stocks, assume that the potential return of stock A is 10% and the potential return of stock B is 12%. The opportunity cost of investing in Share A is the potential 2% return that can be achieved by investing in Share B. On the other hand, when an investor purchases any stock, he will not be able to use the resource in question in another investment instrument. Therefore, the opportunity cost of a stock is the potential gains that can be obtained in another investment instrument.
From the manufacturer's perspective; When a company considers expanding into new markets or regions, it then weighs the potential rewards of entering new markets against the opportunity cost of abandoning ongoing investments in existing markets or product lines. On the other hand, launching new products or improving existing products requires significant investments. Decision makers evaluate the opportunity cost of allocating resources to product development by weighing the potential benefits of new product development against the opportunity cost of continued investments in other areas.
In terms of states; If a country increases its defense spending, this may lead to a reduction in social spending. In this case, the opportunity cost of increasing defense spending is giving up social spending.
