What is an Opportunity Cost?
An opportunity cost is a profit or value of something that must be given up to acquire or achieve something else—the cost of missing an opportunity.
Every choice you make in life has an opportunity cost because you could have been doing something else instead. It can also be thought of as a trade-off.
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Estimating an Opportunity cost can be used to make countless day-to-day choices like grocery shopping or eating out, but can be especially helpful when dealing with more important financial decisions. From determining whether to abandon your 9-to-5 job to start a business or deciding to buy your first home, it is an important method for choosing the best alternative. Without considering the opportunity cost, a better choice might go completely unnoticed.
Opportunity Cost = Most lucrative option – Chosen option
For example, if you spend $30,000 on a new car, you missed out on the opportunity to invest that money, which over many years could bring in a return of thousands of dollars.
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With a credit card, there are two opportunity costs. First, your future income is reduced by the price of whatever you purchase; you can’t use that money to buy other things. Additionally, you missed out on the opportunity to save that money and have it earn interest. The money that is not saved and could be earning interest would be considered a loss affecting your spending budget in the future.
When starting a business, there are many opportunity costs to consider. You could use the capital for investing instead of putting it into the business. An investment will more likely earn interest or increase in value if you invest in the market, whereas a startup has more risk and is more likely to fail. Additionally, the time you put into the business has value. The money you could otherwise earn as a salaried employee is also an opportunity cost.
- Although the term “opportunity cost” was coined by an Austrian economist, the inspiration was Benjamin Franklin’s theory of “time is money”. In 1746 he wrote:
“Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.”
- If you spent the money on Apple stock rather than on purchasing the original iPod in 2001 ($499), you would have earned approximately $14,514 today.