Opportunity Cost Explained
What opportunity cost means, why it matters and how to identify it in an example.
Resources such as time, money and materials are limited, so every choice involves giving something up. Opportunity cost is the value of the next best alternative you give up when you make a choice.
Key point
It is the best alternative forgone, not the total of all alternatives.
Example 1: personal
Maria has a free evening. She could study (value to her: a better grade), work a shift (paying 60), or see friends. She chooses to study. If working would have been her next best option, her opportunity cost is the 60 she would have earned, not also the enjoyment of seeing friends.
Example 2: business
A bakery has one oven. It can bake bread worth 400 per day or cakes worth 500 per day, but not both at the same time. If it bakes cakes, the opportunity cost is the 400 of bread.
Example 3: government
A government spends money on a new road. The opportunity cost is the next best use of that money, such as a hospital or school.
Opportunity cost and decision-making
Comparing opportunity costs helps decide the best use of limited resources. If the value of the chosen option is higher than the value of the best alternative, the choice makes sense.
Common mistakes
- Counting all alternatives instead of the best one.
- Ignoring non-money costs such as time.
- Confusing opportunity cost with the money spent.
Quick recap
Opportunity cost is the value of the best alternative forgone. It exists because resources are scarce.