This definition emphasizes that the cost of an action includes the monetary cost as well as the value forgone by taking the action. The opportunity cost of spending $19 to download songs from an online music provider is measured by the benefit that you would have received had you used the $19 instead for another purpose. The opportunity cost of a puppy includes not just the purchase price but the food, veterinary bills, carpet cleaning, and time value of training as well.
Sunk costs
Again, such a valuation approach converts a bundle of disparate attributes into a monetary value. Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to invest, and it can’t be recouped without selling the stock (and perhaps not in full even then). Using the simple example in the image, to make 100 tonnes of tea, Country A has to give up the production of 20 tonnes of wool which means for every 1 tonne of tea produced, 0.2 tonnes of wool has to be forgone. Meanwhile, to make 30 tonnes of tea, Country B needs to sacrifice the production of 100 tonnes of wool, so for each tonne of tea, 3.3 tonnes of wool is forgone.
Module 1: Economic Thinking
Opportunity cost is generally the easiest to calculate when it comes to financial situations, where the value of each of the available options can be quantified in a monetary sense. However, the concept of opportunity cost can also be beneficial in other situations, such as when deciding which hobbies or relationships to pursue, where the value of the different options is often more difficult to quantify. The concept of opportunity cost has important implications both in business and in everyday life, so it’s important to understand it. As such, in the following article you will learn more about opportunity cost, and understand how you can account for it as effectively as possible.
- On the other hand, to make 1 tonne of wool, Country A has to give up 5 tonnes of tea, while Country B would need to give up 0.3 tonnes of tea, so Country B has a comparative advantage over the production of wool.
- Despite the fact that sunk costs should be ignored when making future decisions, people sometimes make the mistake of thinking sunk cost matters.
- Opportunity cost is generally the easiest to calculate when it comes to financial situations, where the value of each of the available options can be quantified in a monetary sense.
- For example, if a person chose to invest in a certain venture, their opportunity cost is the money they could have made by investing in a different venture, and namely in the best alternative venture that was available to them.
- However, the cost of the assets must be included in the cash outflow at the current market price.
4: The Concept of Opportunity Cost
For example, the cost of a university education includes the tuition and textbook purchases, as well as the wages that were lost during the time the student was in school. Indeed, the value of the time spent in acquiring the education is a significant cost of acquiring the university degree. Room and board would not be a cost since one must eat and live whether one is working or at school.
Furthermore, in this regard, it’s important to remember that ‘not making a decision’ is a decision in itself, which should be evaluated just like any other option. The fundamental economic problem of having limited resources to meet unlimited wants and needs. The available options such cases can be described as being on a par, meaning that they’re not necessarily better or worse than one another, but are rather on roughly the same level, despite being distinctly different from one another.
Learning ObjectiveS
Because of scarcity, every time we do one thing we necessarily have to forgo doing something else desirable. So there is an opportunity cost to everything we do, and that cost is expressed in terms of the most valuable alternative that is sacrificed…. Furthermore, the above study showed that a similar issue can arise in situations where people fail to follow through and take advantage of an original option that they planned to take advantage of. Specifically, when this happens, people sometimes feel that by failing to use the option that they chose, they simultaneously missed out on all the alternative options that they didn’t choose, though in reality they could have only picked one of them.
Opportunity cost can also be used to assess past decisions, which can be beneficial in some situations. For example, you might assess the opportunity cost of a previous decision that you made if you believe that you will benefit from doing so by learning an important lesson about your decision-making process, which will help you when it comes to future decisions. Though people often underestimate or ignore opportunity costs, there are also situations where the opposite is true. Despite the benefits of accounting for opportunity cost, many people and organizations neglect to do so when making decisions. Fortunately, however, there are some things that you can do in order to ensure that you will properly keep opportunity cost in mind when necessary.
In this case, Country A has a comparative advantage over Country B for the production of tea because it has a lower opportunity cost. On the other hand, to make 1 tonne of wool, Country A has to give up 5 tonnes of tea, while Country B would need to give up 0.3 tonnes of tea, so Country B has a comparative advantage over the production of wool. The alternatives that must be given up when one option is chosen over another, highlighting the choices faced when resources are limited.
Economists think of cost in a slightly quirky way that makes sense, however, once you think about it for a while. We use the term opportunity cost to remind you occasionally of our idiosyncratic an opportunity cost is best described as apex notion of cost. For an economist, the cost of buying or doing something is the value that one forgoes in purchasing the product or undertaking the activity of the thing.
