Every choice has an opportunity cost: the next best alternative you give up.
Opportunity cost is the next best alternative forgone when a choice is made. It is not everything you give up, only the single best thing you could have done instead. It exists because resources are scarce.
Opportunity cost shapes decisions. A consumer who spends on a concert ticket gives up the next best purchase. A worker who takes a job gives up the next best job or time spent studying. Rational decision-makers compare the benefit of a choice with its opportunity cost.
Firms face opportunity cost when they use money, space or staff for one product instead of another. Governments face it too. Spending more on defence can mean less spending on healthcare, unless taxes rise or the government borrows.
Opportunity cost changes decisions when it changes. If wages in jobs available to school leavers rise, the opportunity cost of further study rises, and some people may choose to work instead.
- Opportunity cost
- The next best alternative forgone when a choice is made.
- Why it exists
- Resources are scarce, so choosing one use means not choosing another.
- Decision rule
- Choose an option when its benefit exceeds its opportunity cost.
Worked example: Should a firm spend on new machinery?
A bakery has $40,000. Its best options are a new oven, a delivery van or a marketing campaign. It ranks the van second.
- State the choice: the bakery buys the oven.
- Identify the opportunity cost: the next best alternative, the delivery van, is given up.
- Explain the influence: the bakery buys the oven only if it expects the oven to bring more benefit than the van would.
- Note what is not the opportunity cost: the marketing campaign was third choice, so it is not counted.
Watch out for this
The opportunity cost of buying a $20 book is $20.
The $20 is the price. The opportunity cost is the next best thing that $20 could have bought or done, such as a movie ticket and popcorn.
Check your understanding
Mei Ling can work a Saturday shift for $80, study for a test, or go to the beach. She values studying second and the beach third. She chooses the shift. What is her opportunity cost?
- The time she could have spent studying
- Studying and going to the beach
- The $80 she earns