Opportunity costs explained

My lunch bagWhen faced with a decision, opportunity costs are the costs of foregoing income from choosing one alternative instead of another.

For example, suppose that you are trying to decide whether to

  1. Go out for lunch in a restaurant today or
  2. Bring lunch and eat it at your desk.

Lunch costs $2.00 to make. Lunch in the restaurant costs $6.00. Therefore you would clearly save $4.00 by bringing your own lunch rather than eating in a restaurant.

Here’s where opportunity costs come in. Suppose you get paid $10 per hour. Eating at your desk frees you up to work one more hour and earn $10 more. This is an opportunity cost of eating in the restaurant – you must forego $10 in income.

Therefore, the real cost of going out for lunch in a restaurant is $6.00 for food and $10.00 in opportunity cost = $16.00 The real cost of bringing lunch remains $2.00.  Therefore, the desk lunch saves you $14.00.

Businesses inevitably have capacity problems. They are limited in how much they can produce, how much they can sell, or how much showroom floor space they have. This means that most decisions inevitably involve foregoing other choices, i.e. opportunity costs. For example, your clothing store decides to stock a new line of sweaters. Will another line of products lose shelf space? Will selling these sweaters reduce sales of other products? This foregone income can be measured as opportunity costs.

So, too, in finance. Choosing to put money in a certain investment, means choosing not to put that money into other investments. The income not earned by the other investments (because you chose not to invest in them) would be opportunity costs.

When making decisions, managers must consider opportunity costs. However, because opportunity costs don’t represent real transactions, Generally Accepted Accounting Principles don’t recognize them, and omit their effects from financial statements.

{Image: My lunch bag by daveynin, on Flickr]

2 thoughts on “Opportunity costs explained

  1. The current administration (in the US) is focused on jump starting the economy with aggressive spending; however many policymakers insist this makes the budget deficit unsustainable. How is this issue related to opportunity costs, choice, and scarce resources?

    • It’s a complex question – Lawmakers have two conflicting factors here: (1) Keeping the federal deficit down by reducing federal expenditures and (2) increasing federal expenditures in order to “pump up” the economy. Opportunity costs play an important role here because any dollar spent for something is a dollar that can’t be spent for something else. By choosing to spend money in one way (say on increased daycare centers, as I heard on the radio today), the government is choosing not to spend the money in another way (say, military spending or healthcare). The basic principle should be to send scarce resources where they would do the most good. However, in practice, this is not so simple.

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