Opportunity cost

In microeconomic theory, the opportunity cost of an activity or option is the loss of value or benefit that would be incurred (the cost) by engaging in that activity or choosing that option, versus/relative to engaging in the alternative activity or choosing the alternative option that would offer the highest return in value or benefit (the best forgone opportunity).

In basic equation form, opportunity cost can be defined as:

Opportunity Cost = FO (returns on best forgone option) CO (returns on chosen option)[1]

Directly or indirectly, opportunity cost underpins the majority of day-to-day economic decisions that are made in society.[2] For example, the opportunity cost of mowing one’s own lawn for a doctor or a lawyer (who might otherwise make $100 an hour if they elected to work overtime during that time instead) would be higher than for a minimum-wage employee (who in the United States might earn $7.25 an hour), which would make the former more likely to hire someone else to mow their lawn for them.

As a representation of the relationship between scarcity and choice,[3] the objective of opportunity cost is to ensure efficient use of scarce resources.[4] It incorporates all associated costs of a decision, both explicit and implicit.[5] Opportunity cost also includes the utility or economic benefit an individual lost, if it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded in to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income.[4]

However time spent chasing after an income might have health problems like in presenteeism where instead of taking a sick day one avoids it for a salary or to be seen as being active.

A production possibility frontier shows the maximum combination of factors that can be produced. For example if services were on the x axis of a graph and there were to be an increase in services from 20 to 25, this would lead to an opportunity cost for the goods that are on the y axis, as they would drop from 21 to 16. This means that as a result of the increase in consumption of services, the opportunity cost would be those 5 goods that have decreased.[6]

Regardless of the time of occurrence of an activity, if scarcity was non-existent then all demands of a person are satiated. It’s only through scarcity that choice becomes essential, since the use of scarce resources in one way prevents its use in another way, resulting in the need to make a selection and/or decision.[3]

Sacrifice is a given measurement in opportunity cost of which the decision maker forgoes the opportunity of the next best alternative.[7] In other words, to disregard the equivalent utility of the best alternative choice to gain the utility of the best perceived option.[8] If there were decisions to be made that require no sacrifice then these would be cost free decisions with zero opportunity cost.[9] Only through the analysis of opportunity cost, the company can choose the most beneficial project, based on when the actual benefits are greater than the opportunity cost, so that the limited resources can be optimally allocated to achieve maximum efficiency.