Use the next-best feasible alternative, not every option rejected.
Opportunity cost is the value of the next-best feasible alternative forgone, or given up, when a choice is made. Identify the decision maker and the alternatives they could actually choose, then establish their ranking. Do not add the benefits of mutually exclusive rejected options as though all could have been taken together. Opportunity cost may involve time, output, satisfaction or a financial return. The money paid is relevant to a decision but is not automatically a complete measure of what is forgone.
- Opportunity cost
- The value of the next-best feasible alternative forgone: the best other option you could have chosen but give up when you make this choice.
- Feasible alternatives
- Feasible means possible with the resources available. If only one activity fits a time slot, the opportunity cost is the best rejected activity, not all rejected activities added together.
- Whose value?
- The next-best option depends on the decision maker's priorities. Its value may be pay, output, satisfaction or another benefit; a cash payment does not always capture the whole opportunity cost.
Avoid counting the forgone alternative twice
Start with feasible options
An attractive option that cannot be carried out with the available resources is not automatically the next-best feasible alternative. If a constraint could be relaxed, explain the cost of doing so.
Use one consistent comparison
If the value of an alternative is already measured after subtracting its relevant costs, do not subtract those same costs again. If a payment uses money that could buy something else, explain the forgone purchasing opportunity rather than adding a duplicate money cost.
A free good versus a free ticket
A free good in economics has no opportunity cost because it is available in enough quantity for the uses people want in that situation. A free ticket only means a zero admission price. Attending can still use scarce time, transport and space, so the person and society can still give up other opportunities.
Worked example: Three uses for a workshop
A firm has one free workshop slot. It can repair equipment, make shelves or rent out the space. After accounting for the costs each option would cause and its relevant non-financial benefits, it ranks repairing first, shelving second and renting third. Only one use can take place in the slot.
- Identify the chosen use: repairing equipment. The decision concerns this workshop slot.
- Of the rejected feasible alternatives, making shelves is ranked highest. The value of that shelving opportunity is the opportunity cost of repairing.
- Do not add the shelving and rental opportunities: the firm could not have used the one slot for both.
- If a consumer chooses revision over their next-best use of an evening, the forgone value is that alternative activity. If government chooses a clinic over the best alternative use of a site, the forgone public benefit belongs in its comparison.
Watch out for this
Opportunity cost is the sum of all the alternatives I did not choose.
Use the best feasible alternative forgone. If an alternative is itself a feasible combination of activities, value that combination; do not invent combinations the constraint rules out.
Check your understanding
A student chooses a two-hour shift instead of revision or a film. The three options are mutually exclusive. They rank revision above the film. What is the opportunity cost of the shift?
- The value of the two hours of revision forgone.
- The combined value of revision and the film.
- The pay earned on the shift.