Opportunity cost refers to the potential benefits that an individual, investor or business gives up when choosing one option over another.
Opportunity cost refers to the potential benefits that an individual, investor or business gives up when choosing one option over another. For example, if you invest in your future career prospects by going back to college, you may not be able to work while studying, so your lost earnings over this period would be part of your opportunity cost. This must be balanced against the longer-term benefits of the decision. Understanding the value of opportunity costs can guide you in making better investing and savings decisions.
Understanding opportunity cost
Opportunity cost applies to almost any business or personal decision, but it can be an elusive concept to grasp because it is so broad. In general, opportunity cost is the amount of money (or another resource) that you will miss out on by taking a particular course of action. However, defining that cost can be difficult, because it doesn’t always relate to a tangible asset.
Explicit costs refer to direct payments and are often easy to relate to opportunity costs. Say you own a restaurant and add a new soup of the day to your menu. Your explicit costs could total $20, which include labor, electricity, ingredients and water. Your opportunity cost in this situation is what you could have done with that $20 had you chosen not to add a new soup to the menu. Instead, you could have increased wages, purchased more kitchen utensils, donated to charity or put the money in a retirement account to earn interest.
Implicit costs are sometimes more difficult to relate directly to opportunity costs, because they are not direct payments for goods or services. Instead, implicit costs are indirect costs that represent a lost opportunity to generate income with the resources you already have. For example, consider someone who is contemplating listing their vacation home on Airbnb or Vrbo. It costs the homeowner nothing to use the property when they need some time and a place to get away. However, if they rent their home out to others, they could generate rental income. In this situation, the lost revenue from the rental is an opportunity cost.
Opportunity costs are also related to sunk costs. Sunk costs refer to money or resources spent in the past by pursuing a specific course of action. Often, people hesitate to change their mind or abandon an unsuccessful course of action because of a high sunk cost; they don’t want to have “wasted” that loss. In many cases, however, an analysis of opportunity cost will reveal that it is better to abandon a mistaken course of action despite the short-term implications of doing so.
Examples of opportunity cost
People face many decisions throughout their lives, from day-to-day choices about what to eat for breakfast to significant decisions about whether to have children, where to go to college and whether to buy a house. Sometimes there are only two alternatives, but sometimes multiple options are involved. Here are some situations where the idea of opportunity cost is relevant.
Buying vs. renting a home
Choosing to buy a home is a major life decision and often your largest purchase. However, you might struggle to make the jump from renting even though you are financially fit enough to make the purchase.
Renting comes with opportunity cost — that is, the benefits you miss out on by choosing not to buy a house. Examples of opportunity costs related to renting include:
- Rent payments do not build ownership. Each time a homeowner makes a mortgage payment, a portion of it goes to the principal, allowing them to build equity and eventually own their home outright.
- Renters do not benefit from appreciation. Although there are short-term market cycles, most real estate appreciates in the long term, increasing a homeowner's net worth.
- Renters do not receive tax benefits. Homeowners can take advantage of various tax deductions that save them money.
Other examples of opportunity cost
Recognizing opportunity cost sometimes alters individual behavior, as it depends on how different people interpret and process it. For example, imagine you spend $10 for lunch each day when you are at work, but it might only cost around $4 per day if you made your own lunch. Therefore, the opportunity cost of buying lunch at work each day is $6 ($10 − $4).
Other examples of opportunity costs include:
A college student decides to go out for dinner and drinks with friends, and spends $75 the night before midterms. The opportunity cost is study time and money to spend on other things.
A commuter rides the train to work each day for 90 minutes instead of driving for 60 minutes. The opportunity cost is an hour to spend doing something else each day.
Calculating opportunity cost
Calculating opportunity costs means starting with a broad understanding of how opportunity cost works and how it relates to scarcity and risk, and not all situations are conducive to quantifying opportunity cost. However, when money is involved, it's easier to come up with a monetary value to assign to opportunity cost.
The formula for calculating opportunity cost is:
Opportunity cost = FO − CO
FO = Return on the forgone option
CO = Return on the chosen option
Opportunity cost is the difference in the benefits received between the option chosen (CO) and an option you did not choose (FO). This formula considers the measurable outcome of two different actions so you can better consider the opportunity cost of different paths so you can choose the preferred outcome.
Consider someone who is faced with the following two choices:
- Option 1: Invest savings in the stock market
- Option 2: Leave savings in an interest-bearing account
Assume that the expected ROI in the stock market is 10% over the next year, and your high-yield savings account has an annual rate of 2%. The opportunity cost of leaving your savings in an interest-bearing account is 8% (10% − 2%). In other words, by leaving your money in a savings account, you forgo the opportunity to earn more money by investing in the stock market.
However, fully evaluating the outcome of different opportunities can be complex. After all, it is not a foregone conclusion that investments will perform well or at a specific rate of return. For a more insightful analysis, savers should also consider the relative opportunity cost of investing the money before a market downturn. If, in this example, the market produces an annual rate of return of -5%, the cost of investing becomes higher than the cost of saving money in a savings account. Ultimately, it’s important to consider multiple potential outcomes — and risks — when assessing the opportunity cost of different financial decisions.
Why does opportunity cost matter?
Generally speaking, understanding opportunity cost provides more complete information for decision-making. From a business standpoint, opportunity cost informs how a business finances its growth and operations, as businesses use a combination of debt and equity to compensate lenders and shareholders for their investment. For example, using capital to make loan payments ties up that money so it cannot be invested. As a result, you are potentially missing out on income from stocks, bonds or other investments. The trade-off in this example is deciding whether leveraging debt will lead to more profits than investing capital.
Opportunity cost also matters for individuals when making financial decisions.
For example, if traders or investors are day trading on the stock market or making long-term investments in stocks and/or bonds, they need to decide how much cash to keep on hand. This is especially true during an economic downturn and a bear market when people typically want more cash on hand for emergencies.
Allocating income and resources for one purpose prevents you from using your income or resources for another purpose. Do you keep your cash liquid in savings or do you use your savings for a down payment on a home? Do you use your savings to buy the new car you need, or do you take out a loan?
In all these situations, evaluating opportunity cost helps you make more informed decisions.