From a macroeconomic perspective, the PPF illustrates the production possibilities available to a nation or economy during a given period of time for broad categories of output. It is traditionally used to show the movement between committing all funds to consumption on the y-axis versus investment on the x-axis. However, an economy may achieve productive efficiency without necessarily being allocatively efficient. When launching a new product or company, an entrepreneur must consider their biggest cost – the opportunity cost. Opportunity cost is an economic term that is defined as the cost of passing up the next best alternative when making a decision.
Even clipping coupons versus going to the supermarket empty-handed is an example of an opportunity cost unless the time used to clip coupons is better spent working in a more profitable venture than the savings promised by the coupons. Opportunity costs are everywhere and occur with every decision made, big or small. If they’re cautious about a purchase, many people just look at their savings account and check their balance before spending money.
To understand the law of increasing opportunity costs, let’s first define opportunity costs. Opportunity cost is the cost of what you are giving up to do what you are currently doing. If you can either go to work or go to the beach, and you choose to work, the opportunity cost of working is the value you would have gotten had you gone to the beach. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good.
Companies must take both explicit and implicit costs into account when making rational business decisions. What does opportunity cost have to do with a business’s capital structure? If you finance your capital through debt, you have to pay it back even if you aren’t making any money. Moreover, money allocated to servicing debt can’t be spent on investing in the business or pursuing other investment opportunities, such as the stock and bond markets. Let’s look at an example on how a business can use opportunity cost analysis to determine whether or not obtaining an infusion of capital through debt is a smart move.
Opportunity cost definition
The difference between an opportunity cost and a sunk cost is the difference between money already spent and potential returns not earned on an investment because the capital was invested elsewhere, possibly causing financial distress. Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to make an investment, and getting that money back requires liquidating stock at or above the purchase price. When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, they can determine this by looking at the expected rate of return for an investment vehicle.
Say an arcade decides to replace an old pinball machine with a new video game. The income lost from the old pinball machine represents the opportunity cost arising from this decision.
Opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. Opportunity costs are fundamental costs in economics, and are used in computing cost benefit analysis of a project. Such costs, however, are not recorded in the account books but are recognized in decision making by computing the cash outlays and their resulting profit or loss. Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision.
For instance, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose for which the asset could have been used. In the entrepreneur’s case, this asset typically includes the entrepreneur’s time and money.
Still, one could consider opportunity costs when deciding between two risk profiles. If investment A is risky but has an ROI of 25% while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the opportunity cost of going with option B will be salient. As an investor that has already sunk money into investments, you might find another investment that promises greater returns. The opportunity cost of holding the underperforming asset may rise to where the rational investment option is to sell and invest in the more promising investment.
Opportunity costs in production
The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments. The law of increasing opportunity costs states that as you increase production of one good, the opportunity cost to produce an additional good will increase.
If you expect the project to yield returns above the opportunity cost, then it may be a good investment. The law of increasing opportunity cost is the concept that as you continue to increase production of one good, the opportunity cost of producing that next unit increases. This comes about as you reallocate resources to produce one good that was better suited to produce the original good. Therefore, the cost is losing more units of the original good to produce one more of the new good.
For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision. This is a simple example, but the core message holds true for a variety of situations. It may sound like overkill to think about opportunity costs every time you want to buy a candy bar or go on vacation.
Thus, while 1,000 shares in company A might eventually sell for $12 a share, netting a profit of $2,000, during the same period, company B increased in value from $10 a share to $15. In this scenario, investing $10,000 in company A netted a yield of $2,000, while the same amount invested in company B would have netted $5,000. The $3,000 difference is the opportunity cost of choosing company A over company B. Assume that, given a set amount of money for investment, a business must choose between investing funds in securities or using it to purchase new equipment.
- Say that you have option A, to invest in the stock market hoping to generate capital gain returns.
- The formula for calculating an opportunity cost is simply the difference between the expected returns of each option.
When it comes down to personal finance, one economic principal rules the roost – opportunity cost. With more household incomes stretched to the limits in the wake of the global economic slowdown, this principal is quickly becoming a budgeting essential. However, the rule doesn’t just affect what we spend our money on – it also dictates much of our personal finance lives. From our careers and our individual housing situations to how we invest and where to go to school, understanding the opportunity costs concerning these decisions is key for a sound financial footing.
Option B is to reinvest your money back into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin. For the sake of simplicity, assume the investment yields a return of 0%, meaning the company gets out exactly what it put in. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The opportunity cost of choosing this option is then 12% rather than the expected 2%. Assume the expected return on investment in the stock market is 12 percent over the next year, and your company expects the equipment update to generate a 10 percent return over the same period.
Use ‘opportunity cost’ in a Sentence
A fundamental economic analysis – whether you’re running a country, a business or your personal finances – determines the opportunity costs of a decision. In this lesson, you’ll learn about opportunity cost, its formula and how to calculate it. One example of opportunity cost is in the evaluation of “foreign” (to the US) buyers and their allocation of cash assets in real estate or other types of investment vehicles. In business, opportunity costs commonly arise from the reality that businesses have limited resources.
No matter which option the business chooses, the potential profit it gives up by not investing in the other option is the opportunity cost. Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful.
However, businesses must also consider the opportunity cost of each option. Opportunity cost analysis also plays a crucial role in determining a business’s capital structure. While both debt and equity require expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds used to make payments on loans, for example, are not being invested in stocks or bonds, which offer the potential for investment income.
Because opportunity cost is a forward-looking calculation, the actual rate of return for both options is unknown. Assume the company in the above example foregoes new equipment and invests in the stock market instead. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12 percent return. For a capital investment project, a company should evaluate the expected return of the investment compared to the opportunity cost. Opportunity costs are also the expected returns of an alternative investment of equal risk.
It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk-free, to investment in a highly volatile stock can cause a misleading calculation. Government backs the rate of return of the T-bill, while there is no such guarantee in the stock market. While the opportunity cost of either option is 0 percent, the T-bill is the safer bet when you consider the relative risk of each investment.
The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Say that you have option A, to invest in the stock market hoping to generate capital gain returns.
Often, people don’t think about the things they must give up when they make those decisions. Again, an opportunity cost describes the returns that one could have earned if he or she invested the money in another instrument.
Thus, MRT increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF. If you decide to spend money on a vacation and you delay your home’s remodel, then your opportunity cost is the benefit living in a renovated home. For time management, if you decide to spend time working late at the office on an important project, your opportunity cost is the benefit of spending quality family time at home. In business, opportunity costs play a major role in decision-making. If you decide to purchase a new piece of equipment, your opportunity cost is the money spent elsewhere.
The opportunity cost of choosing the equipment over the stock market is (12% – 10%), which equals two percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.
The slope of the production–possibility frontier (PPF) at any given point is called the marginal rate of transformation (MRT). The slope defines the rate at which production of one good can be redirected (by reallocation of productive resources) into production of the other. It is also called the (marginal) “opportunity cost” of a commodity, that is, it is the opportunity cost of X in terms of Y at the margin. It measures how much of good Y is given up for one more unit of good X or vice versa. The shape of a PPF is commonly drawn as concave to the origin to represent increasing opportunity cost with increased output of a good.
What is an example of an opportunity cost?
August 08, 2019. Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%.