Opportunity cost
Opportunity cost is an essential economic principle that represents the value of the best alternative that is forgone when making a choice between two or more mutually exclusive options. It highlights the trade-offs involved in resource allocation, particularly in situations where resources are limited. For instance, if a company opts to increase the production of one product, it must reduce the output of another, thus incurring an opportunity cost reflected by the lost potential revenue from the neglected option.
The concept was notably advanced by Austrian economist Friedrich von Wieser, who argued that costs should be evaluated based on utility rather than just supply and demand. Opportunity cost applies to both individual and corporate decision-making, considering both monetary and non-monetary factors. For example, a professional might weigh the financial benefits of outsourcing chores against the personal satisfaction derived from performing them. Ultimately, opportunity cost serves as a vital tool for assessing the relative value of various choices and helps individuals and organizations make informed decisions about how to best utilize their resources.
On this Page
Subject Terms
Opportunity cost
Opportunity cost is an economic principle that refers to the value of an option that was not chosen in a choice between two or more mutually exclusive options. Opportunity cost measures the value of a missed opportunity in situations where resources are limited and must be utilized for one opportunity at the expense of another. For example, if a company decides to use its limited factory space and other resources to increase production of Product A, it must simultaneously decrease the output of Product B. To accurately calculate the value of increasing the production of Product A, the company stakeholders must deduct the cost of the lost output of Product B (the opportunity cost). Opportunity cost is a useful tool for determining the most profitable use of available resources.
Overview
Austrian economist Friedrich von Wieser (1851–1926) has been credited with developing the concept of opportunity cost in his 1884 thesis Über den Ursprung und die Hauptgesetze des wirthschaftlichen Werthes (On the origin and main laws of economic value); he expanded on the idea in his 1889 book Der Natürliche Werth (Natural Value). Wieser was interested in developing a subjective theory of value that interprets costs based on utility rather than the determinants of supply and demand.
Opportunity cost considers the profit an individual or corporation could have earned if its capital, equipment, real estate holdings, person-hours, or other resources had been used in a different way. The concept of opportunity cost applies only to situations in which resources are limited and alternative options are available. If no alternative options for resource allocation exist or if resources are unlimited, then the opportunity cost of a decision is zero. In calculating opportunity costs, businesses must consider costs that are not normally recorded in the accounting system because opportunity costs require no immediate cash outlays. Although opportunity cost does not necessarily measure monetary cost, it is an important tool for determining the relative value of various resource-allocation opportunities.
As an example of an opportunity cost, consider Frank, a psychotherapist who earns an hourly rate of $100. Frank spends three hours a week cleaning his home. However, Frank realizes he can pay a housekeeper $20 an hour to perform those chores for him, which would free him to take on three more hourly appointments per week, earning him an additional $300 minus the $60 spent on the housekeeper. The opportunity cost of continuing to do his household chores himself is the $240 weekly profit he could have earned if he had decided to outsource his housekeeping. However, if Frank finds housework relaxing or enjoyable, then he may determine that the additional $240 in weekly profit is worth less than the enjoyment he gets from housework and decide it is worthwhile to continue to perform all household chores himself. In this way, the concept of opportunity costs accounts for both monetary and nonmonetary costs in determining the relative value of various resource-allocation decisions.
Bibliography
Barnett, William, II, and Walter E. Block. “Subjective Preferences and Alternative Costs.” Journal of Philosophical Economics, vol. 6, no. 2, 2013, pp. 2–15.
Drury, Colin. Management Accounting for Business. 4th ed. Cengage Learning EMEA, 2009.
Gill, Betty, Barbara Griffin, and Beryl Hesketh. “Changing Expectations Concerning Life-Extending Treatment: The Relevance of Opportunity Cost.” Social Science and Medicine, vol. 85, May 2013, pp. 66–73, doi:10.1016/j.socscimed.2013.02.040. Accessed 1 Oct. 2024.
Hoffmans, Lara. “The Risk of Ignoring Opportunity Cost.” Forbes, 11 Dec. 2012, www.forbes.com/sites/larahoffmans/2012/12/11/opportunity-cost-ken-fisher/. Accessed 1 Oct. 2024.
“Opportunity Cost: Choose the Right Products and Services to Offer.” Bloomberg Businessweek, 12 Aug. 2010, www.bloomberg.com/news/articles/2010-08-12/opportunity-cost-choose-the-right-products-and-services-to-offer. Accessed 1 Oct. 2024.
Oster, Emily. “Time Is Money.” Slate, 6 Feb. 2013, slate.com/human-interest/2013/02/time-is-money-opportunity-cost-can-help-you-figure-out-how-much-your-time-is-worth.html. Accessed 1 Oct. 2024.
Spiller, Stephen A. “Opportunity Cost Consideration.” Journal of Consumer Research, vol. 38, no. 4, 2011, pp. 595–610.
Walsh, Ben. “The Opportunity Costs of Buying iPhones and Cronuts.” Reuters, 20 Sept. 2013, www.reuters.com/article/world/the-opportunity-cost-of-buying-iphones-and-cronuts-idUS909681277/. Accessed 1 Oct. 2024.