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Opportunity Cost

April 21, 2024
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FinMeUp
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FinMeUp

Every decision we make has both an explicit, accounting cost and an inplicit, economic cost.

Individuals and businesses often consider only accounting costs when making decisions. There is nothing wrong with this approach, but the calculation is missing an essential input from an economic point of view: opportunity cost. 

Opportunity cost is the cost of the best alternative not chosen. Its essentially what we give up when making decisions. Economists argue that every decision we make has both an explicit, accounting cost and an implicit, opportunity cost.

Lets look at a few examples:

The opportunity cost of keeping money in our pockets represents foregone capital appreciation via share investments.

The opportunity cost of studying for an hour represents the forgone value of watching an episode from your favourite series.

The opportunity cost of public transportation is the value given up by traveling in your own car.

The opportunity cost of choosing McDonalds for dinner is the value foregone from having KFC.

The opportunity cost of partying with your friends the evening before the exam represents 10% on your final mark.

How should we make decisions?

So, how should be make decisions? Well, basically how weve been doing it all along. We view options A and B and make our decision based on the option which gives us the best value for money. We must just be aware that our every decision includes an implicit, foregone interest. This minor change in awareness will enable us to make more informed decisions:

Accountant: I want to go to the movies tonight. It will cost me the sum of the petrol, snacks, and movie. It is expensive, but its worth it. I will go watch the movie.

Economist: I want to go to the movies tonight. It will cost me the sum of the petrol, snacks, movie, and the value of staying home and chilling on the couch. I value staying home quite a bit, especially after a long week at work. This is too expensive, I will rather chill at home.


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