Definition and Examples of Opportunity Cost
Opportunity cost is the value of what you lose when choosing between two or more options. When you decide, you feel that the choice you've made will have better results for you regardless of what you lose by making it. As an investor, opportunity cost means that your investment choices will always have immediate and future losses or gains.
- Alternative definition: Opportunity cost is the loss you take to make a gain, or the loss of one gain for another gain.
Consider, for example, the choice between whether to sell stock shares now or hold onto them to sell later. While it is true that an investor could secure any immediate gains they might have by selling immediately, they lose out on any gains the investment could bring them in the future.
Another example of opportunity cost is something as simple as choosing between going to work and skipping work. What are you losing out on if you choose one over the other? Opportunity cost doesn't always need to apply to investments or money; it can also apply to life decisions.
How Opportunity Cost Works
When you're faced with a financial decision, you can try to determine the return you'll get from each option. For example, let's say you're entertaining the thought of selling a bond and using the money you'll gain to purchase another. You could visualize the opportunities using this table:
|Weighing Opportunity Cost|
|Current Bond "A"||New Bond "B"|
|Future value could go up||Future value could go up|
|Future value could go down||Future value could go down|
If your current bond "A" has a value of $10,000, you can sell it to help purchase bond "B" at a slightly lower rate. Bond "B" has a face value of $20,000—so you'd spend an additional $10,000 to purchase bond "B." To determine the best choice, you need to weigh the options.
The initial cost of bond "B" is higher than that of "A," so you'd spend more hoping to gain more because a lower interest rate on more money can still create more gains. However, you'd have to make more than $10,000—the amount that came out of your pocket—to add value to bond "B."
In this example, the opportunity costs are continued interest gains on bond "A" and the initial loss of $10,000 on bond "B" while hoping to recover it and increase your profits in the future.
Comparing these measures in hindsight will make them appear more concrete, but keep in mind that such an estimation is only a theoretical difference.
How To Calculate Opportunity Cost
While opportunity cost is not an exact measure, one way to quantify it is to estimate the potential future value that you opted not to receive and compare it with the value of the choice you made instead.
Here's a formula for calculating opportunity cost:
On a basic level, opportunity cost is a common-sense concept that economists and investors like to explore. For example, what would have happened if Walt Disney had never started animating? He might have gone on to do something equally successful, or you may never have heard his name.
Opportunity cost is the proverbial fork in the road, with dollar signs on each path—the key is, there is something to gain and lose in each direction. You make an informed decision by estimating the losses for each decision.
What Opportunity Cost Means for You
If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that nearly every decision requires a trade-off. We live in a finite world—you can't be two places at once.
Every choice made in life has an opportunity cost.
For investors, explicit costs are direct, out-of-pocket payments such as purchasing a stock or an option, or spending money to improve a rental property. Costs can also be wages, utilities, materials, or rent.
For example, if you own a restaurant and add a new item to the menu that requires $30 in labor, ingredients, electricity, and water, your explicit cost is $30.
Your opportunity cost is what you could have done with that $30 had you not decided to add the new item to the menu. You could have given that $30 to charity, spent it on clothes for yourself, or placed it in your retirement fund and let it earn interest for you.
Explicit and implicit costs can be viewed as out-of-pocket costs (explicit) and costs of using assets you own (implicit).
Implicit costs do not represent a financial payment. They're not direct costs to you but rather the lost opportunity to generate income through your resources.
If you have a second house that you use as a vacation home, for instance, the implicit cost is the rental income you could have generated if you leased it and collected monthly rental checks when you're not using it. It doesn't cost you anything upfront to use the vacation home yourself, but you are giving up the opportunity to generate income from the property if you choose not to lease it.
- A decision always has a lost opportunity.
- Each opportunity has losses and gains.
- Opportunity value less actual gain is an estimation of the opportunity cost.
- The same choice will have different opportunity costs for different people.
Frequently Asked Questions (FAQs)
What is the simple definition of opportunity cost?
Opportunity cost is the value of what you lose when choosing between two or more options. Every choice has trade-offs, and opportunity cost is the potential benefits you'll miss out on by choosing one direction over another.
Why does opportunity cost matter?
Understanding opportunity cost can help you make better decisions. When you fully understand the potential costs and benefits of each option you're weighing, you can make a more informed decision and be better prepared for any consequences of your choice.
Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
St. Louis Fed. "Money and Missed Opportunities."
Khan Academy. “Explicit and Implicit Costs and Accounting and Economic Profit.”