Opportunity cost can best be explained by an example. Basically you can think of it as the “unseen cost” rather than “monetary cost”. The unseen cost is what you would have done, if you didn’t do your first preference action.
Imagine you live in North Korea, you can walk into a shop, and they only have 3 products. Cabbage 100 Won Matches 80 Won Toothbrush 200 Won
You have 200 Won and prefer to buy a toothbrush; if there was no toothbrush you would buy the cabbage and matches. In the case below the opportunity cost of getting the toothbrush is the cabbage and matches that were not bought.
Now we assume the toothbrushes are out of stock, so there is only two choices, buy nothing, or the cabbage/matches. This makes the opportunity cost the same as the monetary cost.
In the final case Your preferences change and you decide the actually you would rather have the cash than the toothbrush.
So why is “opportunity cost” important?
Think of this scenario You can either start a business or buy a Ferrari both for $100,000. So the monetary cost is $100,000. But the Ferrari is estimated to be worth $80,000 after year 1 and the Business worth $200,000. So the opportunity cost of buying the Ferrari in monetary terms is $120,000.
So although you might see buying a Ferrari as worth $100,000, would you feel the same if it was to cost you effectively $200,000?
Using “opportunity costs” can help you evaluate decisions better, by including non materialised costs.
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