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.

\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 $= \text{revenue} - \text{explicit costs}$ . Economic profit $= \text{revenue} - \text{explicit costs} - \text{implicit costs}$ . 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.