Arab British Academy for Higher Education.
Opportunity Cost
Scarcity of resources is one of the more basic concepts of economics. Scarcity
necessitates trade-offs, and trade-offs result in an opportunity cost. While the cost of a
good or service often is thought of in monetary terms, the opportunity cost of a decision
is based on what must be given up (the next best alternative) as a result of the decision.
Any decision that involves a choice between two or more options has an opportunity cost.
Opportunity cost contrasts to accounting cost in that accounting costs do not consider
forgone opportunities. Consider the case of an MBA student who pays $30,000 per year
in tuition and fees at a private university. For a two-year MBA program, the cost of
tuition and fees would be $60,000. This is the monetary cost of the education. However,
when making the decision to go back to school, one should consider the opportunity cost,
which includes the income that the student would have earned if the alternative decision
of remaining in his or her job had been made. If the student had been earning $50,000 per
year and was expecting a 10% salary increase in one year, $105,000 in salary would be
foregone as a result of the decision to return to school. Adding this amount to the
educational expenses results in a cost of $165,000 for the degree.
Opportunity cost is useful when evaluating the cost and benefit of choices. It often is
expressed in non-monetary terms. For example, if one has time for only one elective
course, taking a course in microeconomics might have the opportunity cost of a course in
management. By expressing the cost of one option in terms of the foregone benefits of
another, the marginal costs and marginal benefits of the options can be compared.
As another example, if a shipwrecked sailor on a desert island is capable of catching 10
fish or harvesting 5 coconuts in one day, then the opportunity cost of producing one
coconut is two fish (10 fish / 5 coconuts). Note that this simple example assumes that the
production possibility frontier between fish and coconuts is linear.
Relative Price
Opportunity cost is expressed in relative price, that is, the price of one choice relative to
the price of another.
For example, if milk costs $4 per gallon and bread costs $2 per loaf, then the relative
price of milk is 2 loaves of bread. If a consumer goes to the grocery store with only $4
and buys a gallon of milk with it, then one can say that the opportunity cost of that gallon
of milk was 2 loaves of bread (assuming that bread was the next best alternative).
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Arab British Academy for Higher Education.
In many cases, the relative price provides better insight into the real cost of a good than
does the monetary price.
Applications of Opportunity Cost
The concept of opportunity cost has a wide range of applications including:
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Consumer choice
Production possibilities
Cost of capital
Time management
Career choice
Analysis of comparative advantage
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