The opportunity cost is the cost of the alternative that we give up when we make a certain decision, including the benefits that we could have obtained by choosing the alternative option.
Therefore, the opportunity cost is those resources that we stop perceiving or that represent a cost due to the fact of not having chosen the best possible alternative, when there are limited resources (generally money and time). The term opportunity cost is also referred to as «the value of the best option not selected».
In our life we have to constantly make decisions for any matter, especially those related to money. For example, let’s imagine that we have 10 euros and we have several alternatives to spend them (go to the movies, take a walk in the park and save them, have dinner out …), the opportunity cost is going to be the benefit that the alternative to the that we have given up, fundamentally the one with the highest value.
The theory about the opportunity cost tells us that if we have chosen to go see a movie, continuing with the previous example, and while we are watching it we do not like it, thinking economically it is better to leave the cinema and take advantage of the time enjoying another of the alternatives , since the money spent in the cinema we are not going to get it back, it is money that is already spent. But by leaving, at least we can use the time to do something else, like take a walk in the park.
The opportunity cost is used in the financial and economic sphere as a good way to evaluate and quantify investments when we have several possible alternatives and limited resources. In the business field, the opportunity cost is an important element under study since it is one of the best ways to select investments, not because of the profitability in the short and medium term, but above all because the opportunity cost is based on the future profitability (benefits contributed) that each investment may report.
The opportunity cost in finance
In business finance, the so-called opportunity cost of the economic and financial structure refers to the resources that we could earn if we put all our money to work. For example, the money that we have in the bank in an account without remuneration, we could have it in a deposit at 3%, this 3% of the total of our money would be the opportunity cost.
It can also be applied to the use of the own resources of the liabilities of a company, since if instead of using these resources and net worth we use debt, the financial leverage resulting from the use of debt could mean that without using our resources, we would obtain the same benefit .
Opportunity cost examples
If we have € 100,000 and want to invest it, let’s imagine that we can set up a greengrocer or invest in 12,500 Repsol shares, which trade at € 8 on the Madrid Stock Exchange. Since we do not understand much about financial markets, we decided to opt for the greengrocer, which after 2 years brings us € 20,000 in profit, while in those same two years Repsol shares have risen to € 11. In this case the opportunity cost would be:
Greengrocer benefits: 20,000
Repsol shares benefits (discarded): (11-8) x 12,500: € 37,500
Opportunity cost: 37,500-20,000: € 17,500 euros.
Another example of opportunity cost is what a student faces when choosing whether to study or work. Suppose that when you finish your degree you can choose between taking a two-year master’s degree or working in your uncle’s shop, where they offer you 1,250 euros a month. If you decide to study instead of working, the opportunity cost of doing the 2-year master instead of working is 30,000 euros, the cost of 1,250 euros per month for two years.