econ.studio

Glossary term

Opportunity Cost

What you give up when you make a choice — the value of the next-best alternative forgone. The idea behind every trade-off, the gap between economic and accounting profit, and the slope of the production possibilities frontier.

Glossary

Opportunity Cost

Opportunity cost is the value of the best thing you give up when you make a choice. Say you have one free evening and two options: work a shift and earn $60, or stay home and study for tomorrow's exam. If you choose to study, the opportunity cost is $60 — the earnings you forgo. You do not have to spend a dollar for a cost to be real. Every choice carries an opportunity cost because time and money are scarce; using them one way means you cannot use them another way.

Formally, opportunity cost is the value of the next-best alternative forgone when a decision is made. This is why economists draw a firm line between economic cost and accounting cost. Accounting cost counts only explicit costs — the cash payments a business actually makes. Economic cost adds implicit costs: the opportunity costs of resources the decision-maker already owns, such as your own labor or the savings you invested in a venture rather than leaving in a market account. Economic profit subtracts both explicit and implicit costs; accounting profit subtracts only explicit costs, so it tends to overstate how well a firm is doing. The gap between the two is precisely the implicit opportunity cost being ignored. See marginal cost for how opportunity cost shapes per-unit production decisions.

economic profit=total revenue−explicit costs−implicit costs\text{economic profit} = \text{total revenue} - \text{explicit costs} - \text{implicit costs}
economic-profit
Economic profit deducts implicit costs that accounting profit ignores. On a production possibilities frontier, the slope of the frontier at any point is the opportunity cost of one good in terms of the other — how many units of the second good you must give up to produce one more unit of the first.
Scarcity
The condition in which resources are limited relative to wants. Scarcity is what forces choices — and therefore what makes opportunity cost unavoidable. Without scarcity there would be no trade-offs.
Trade-off
The exchange involved in every decision: getting more of one thing means accepting less of another. A trade-off describes the existence of the choice; opportunity cost measures what you give up.
Sunk cost
A cost that has already been paid and cannot be recovered. Because a sunk cost cannot be changed by any future decision, it is not an opportunity cost and should be ignored when evaluating what to do next. Continuing a failing project only because you have already spent money on it is the classic sunk-cost fallacy.
Economic profit vs. accounting profit
Accounting profit =revenue−explicit costs= \text{revenue} - \text{explicit costs}. Economic profit =revenue−explicit costs−implicit costs= \text{revenue} - \text{explicit costs} - \text{implicit costs}. A business can show positive accounting profit while earning zero or negative economic profit if its implicit opportunity costs — owner's time, tied-up capital — exceed the accounting surplus.