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Opportunity cost



"Human action is costly. For every action we take, we necessarily forgo taking innumerable others."

   --  Randy Barnett


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.

 

Action taken : Buying

Monetary cost

Opportunity Cost

Toothbrush

200 Won

Cabbage and matches

 

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. 


Action taken : Buying

Monetary cost

Opportunity Cost

Cabbage and matches

180 Won

180 Won

 

In the final case Your preferences change and you decide the actually you would rather have the cash than the toothbrush.

 

Action taken : Buying

Monetary cost

Opportunity Cost

Nothing

0 Won

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.


  1. Cost must be borne exclusively by the decision maker; it is not possible for cost to be shifted to or imposed on others. 
  2. Cost is subjective; it exists in the mind of the decision maker and nowhere else.
  3. Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept. 
  4. Cost can never be realized because of the fact of choice itself; that which is given up cannot be enjoyed. 
  5. Cost cannot be measured by someone other than the decision maker because there is no way that subjective experience can be directly observed.
  6. Cost can be dated at the moment of decision or choice.


Those who incur the costs of choice are in the best position to know what their alternative opportunities are and how they rank them. For this reason, their interests are likely to be harmed by having choices imposed upon them by others.


 

http://en.wikipedia.org/wiki/Opportunity_cost

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