What is opportunity cost?
There’s opportunity cost of time, and opportunity cost of assets.
Let’s explain opportunity cost using several examples.
Opportunity cost is something that parents bug their teenage children with.
Here’s Tim.
He is planning to spend his whole day playing Fortnite, minding his own business.
His mom is not excited about his plan:
“Get off that couch, get a haircut, and make yourself
useful… get a job!”.
A job opportunity is right around the corner: the local fast food restaurant is looking
for someone to work in the kitchen.
So Tim basically has to make up his mind between two alternatives: playing a game that doesn’t
cost him anything but makes him no money either, and flipping burgers for $9 per hour.
This is where opportunity cost comes in.
If Tim decides to play his computer game, then he walks away from $9 per hour.
Tim gives up the fun of playing his game, and goes to work instead.
But wait!
Maybe there is an even better alternative.
Instead of working at a fast food restaurant, he could be studying.
This is a choice between making money now and making money later.
If he studies hard and graduates, he could be making $27 per hour after graduation.
Here’s the opportunity cost: if he chooses flipping burgers instead of studying, then
he walks away from an additional $18 per hour that he could be making in the future.
Tim quits his job at the fast food restaurant, walking away from making $9 per hour now,
and goes to study instead, which puts him on the road to $27 per hour in the future.
A good follow-up question to ask is: what is the earnings potential from the field of
study that you choose?
In case Tim chooses cultural anthropology for example, he might not be very employable.
Could be that he ends up back at the fast food restaurant making $9 per hour.
Opportunity cost does not just apply to time, but opportunity cost can also apply to assets.
Here’s Tim’s big brother Bob.
He’s got it together!
Bob owns a small retail building.
He could use the building to set himself up as a barber.
He could also rent out the building to Al, who wants to start a shoe shop.
What should he do?
Bob has to make up his mind between two alternatives: using the building himself which doesn’t
cost him anything and gives him the opportunity to earn an income of $30,000 per year as a
barber, or renting out the building to Al for $40,000 per year.
Here’s the opportunity cost: if Bob decides to use the building himself, he walks away
from $10,000.
You could say that, from the perspective of opportunity cost, it is costing him money
to be a barber in his own building.
Opportunity cost is something that economics professors bug their students with, mostly
in the form of hypothetical examples (starting with the words “Let’s assume…”) that
need an opportunity cost calculation.
Most of these opportunity cost problems are plain busywork, as they are full of far-fetched
assumptions, and very few people would ever think like this in real life.
Here’s one such opportunity cost example.
Let’s assume you are running a YouTube channel.
In any given workweek, you have two and only two ways to grow the channel: making new videos,
and optimizing existing videos (thumbnails, titles, keywords, that sort of stuff).
You can either make 8 new videos, or optimize 80 existing videos, or a combination of both activities.
This curve right here is called the Production Possibility Frontier: a curve illustrating
the varying combinations of two activities that can be undertaken when both depend on
the same finite resources (in this case: time).
Let’s collect some data points.
We need to figure out how many existing videos can be optimized when making 1 new video,
2 new videos, 3 new videos, etc.
This results in a table with 9 combinations.
Opportunity cost is simply the trade-off between the two activities.
If you make 0 new videos, you can optimize 80 existing videos.
If you go from 0 to 1 new video, you have to give up only 1 optimized video in that step.
The opportunity cost is 1 optimized existing video.
If you go from 1 to 2 new videos, you have to give up 2 optimized videos in that step.
The opportunity cost is 2 optimized existing videos.
If you go from 2 to 3 new videos, you have to give up 3 optimized videos in that step.
It gets incrementally harder to make new videos, you will have to give up more and more optimized
existing videos.
To go from 7 to 8 new videos, you have to give up 38 optimized existing videos!
We can also use opportunity costs on the other axis.
To go from 0 to 38 optimized videos, you only have to give up 1 new video.
The opportunity cost is 1 new video.
To go from 38 to 52 optimized videos, an increase of 14, you have to give up another new video. Etcetera.
It gets incrementally harder to optimize more existing videos.
What the economics professor is trying to show you is that under these assumptions,
you would be better off splitting your time between making new videos and optimizing existing
videos two weeks in a row, as that would give you a total of 8 new videos plus 138 optimized
existing videos, compared to spending one full week making 8 new videos and not optimizing
any existing ones, and the other week making 0 new videos and optimizing 80 existing ones.
In the chapter on economies of scale and specialization, he is probably going to give you a problem
to work out that has an opposite conclusion!
What if you don’t want to be on the Production Possibility Frontier?
Maybe I just want to make 4 new videos, and optimize 40 existing ones, and then head out
to the beach and spend the rest of the week in the sun!
This point lies within the Production Possibility Frontier.
Economists (who are obsessed with optimization and rationality) would call it possible, but
not optimal.
What if I want to make 7 new videos, and optimize 90 existing ones, all during one workweek?
As this point lies outside the Production Possibility Frontier, it is currently impossible,
given the current state of technology and productivity.
But don’t let that hold you back!
Maybe coffee, and a new laptop, can help you push the Production Possibility Frontier ever
further outward!
Each of them helps you to be more productive, and push the limit!
What is the definition of opportunity cost?
The loss of other alternatives when one alternative is chosen.
Or even more specific and practical: the value a person could have received but gave up in
pursuit of another option.
Want to learn more about business, finance, accounting and investing?
Then subscribe to the Finance Storyteller YouTube channel, and start watching the next
video in the recommendations on the screen.
Thank you.