What exactly is opportunity cost? When you hear “opportunity cost” you are really just hearing a more elegant way of saying “trade-off.” Every time you make a decision, there is always a trade-off to ponder about. You have to analyze what you are gaining as well as what you may be giving up. To put it simply, opportunity cost is the price of the next best thing you could have done had you not made your first choice.
Opportunity cost is part of the Ten Principles of Economic in analyzing how people make decisions. A way to break this down is by referring it as explicit and implicit costs. An Explicit Opportunity Cost (or explicit cost for short) are opportunity costs that involve straight forward monetary payment by the producers. The explicit cost of the factors of production (i.e. resources) not already owned by a producer is the price that the producer has to pay for them.
For example, let’s say that you own a bakery and you added a new product on the menu that needs $20 in labor, ingredients, and electricity. Your explicit opportunity cost is what you could have done with those $20 if you had not chosen to put the new item to the menu. You could have been taken out of the business, given it to charity, spent it on clothes, or added a different item on the menu.
An Implicit Opportunity Cost (or Implicit cost) is the opportunity costs that are not reflected in cash outflow but implied by the failure of the firm to allocate its existing (owned) resources to the best alternative use. For example, let’s say you have a second house that you use as a vacation home. The implicit cost is the rental income you could have made if you leased it to tenants and collected monthly checks instead of used it for your own family.
The concept behind opportunity cost is not only that your resources are always limited. But that the opportunity cost should be measured based on your own personal feelings and values. It is more about the choices you make than about money or resources. It’s about keeping in mind that one action or choice can preclude you from taking advantage of other options.
To summaries, scarcity creates choices, and every choice has a value to us. That value can be looked at in terms of benefits and in terms of cost. Value is not always measured in financial terms but sometimes measured in terms of time or enjoyment. The opportunity cost of a choice is what must be given up in order to take an opportunity. It’s not the opportunity we chose, but the value of the next best alternative we didn’t choose. Every major choice has an opportunity cost.