What Is Opportunity Cost?
A Basic Definition of Opportunity Cost
The most basic definition of opportunity cost is the price of the next best thing you could have done had you not made your first choice. Some economists like to break down opportunity costs into explicit and implicit.
- Explicit Opportunity Cost Definition
An explicit opportunity cost involves cash outlays; money that has to be spent by a producer for the production factors it does not already own. For example, if you own a nice restaurant and you add a new item to the menu that requires $30 in labor, ingredients, electricity, and water, your explicit opportunity cost is what you could have done with that $30 had you chosen not to add the new item to the menu. You could have taken out of the business, given it to charity, spent it on clothes, or added a different menu item.
Implicit Opportunity Cost Definition
An implicit opportunity cost is one that involves what you could have done with resources you already own. For example, if you have a second house that you use as a vacation home, the implicit opportunity cost is the rental income you could have generated if you, instead of using it for your own family, leased it to tenants and collected monthly checks. Implicit opportunity costs normally don't show up anywhere on the balance sheet or income statement but they are most powerful force in determining if an entity is successful.
Expand Your Opportunity Cost Definition Beyond Finance and Economics
Although the concept of opportunity cost is heavily rooted in economic and financial disciplines, opportunity costs should be measured based on your own personal feelings and values. It would be foolish to always seek the highest financial return if that meant, say, becoming a doctor instead of a chef if you prefer to cook, simply because doctors, on average, earn more than chefs.
Quality of life must play a factor in your analysis and more money does not always equal a better life. (Though all else being equal, more money is preferable because it increases the total options you have at your disposal, even if that means you want to write checks to charities that help orphans and widows all day.)
Furthermore, any one opportunity cost decision could spawn nearly infinite permutations of sub- opportunity costs. What if you hadn't gone to the party where you met your spouse? What if you had bought into that financing deal that turned out to be a scam? What if you had gone to Stanford and become best friends with two now-billionaire technology giants? You could go mad trying to figure out all of the things you could have done, so decisiveness is still a virtue. The goal of studying the concept of opportunity cost is not to make yourself constantly second guess your actions or strategy, but to make sure you are cognizant that your choices do have consequences. As you recently learned, even doing nothing is, in and of itself, a choice that has its own opportunity costs.
Opportunity Cost Is Closely Related to Trade-Offs
If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that certain decisions in life have a trade-off. We live in a finite world; you can't be two places at once. That means if you choose one restaurant tonight, you can't choose another. There are trade-offs involved in that decision, including the relative distance and travel time required to reach the establishment, the price of the menu items at each, the level of service, the type of cuisine, and the speed with which the food is brought to your table.
Right now, in fact, you are reading this article when you could have been golfing, or writing, or exercising, or serving at a food bank, or using drugs, or learning a new skill, or jumping on a plane to a random country with nothing but $24 in your pocket. To the extent factors can be controlled, your life is the sum culmination of your past decisions. That, in a nutshell, is the definition of opportunity cost.
On some level, this is common sense stuff that economists like to make difficult. All you have to do is ask yourself:
- What if Walt Disney had never started animating?
- What if Elton John had never composed songs?
- What if Warren Buffett had given up when he was rejected from Harvard Business School?
- What if Thomas Edison had stopped working on the light bulb when he failed the first few thousand times?
- What if Michael Jordan stopped playing basketball when he was cut from his high school team?
- What if Steve Jobs had never returned to Apple to lead its resurgence, fundamentally reshaping the future of technology?
All of life is opportunity cost. You can't escape it. Accept it. Make the best of it. Move on.