What Is Opportunity Cost?

Definition

Opportunity cost refers to the value of the next best alternative that is given up when a choice is made, a concept first introduced by Friedrich von Wieser in 1914.

How It Works

The opportunity cost of a decision is determined by the trade-offs involved in making that choice. For instance, when a company like Boeing decides to allocate its resources to produce more commercial aircraft, it must divert resources away from other potential projects, such as producing military aircraft or investing in research and development. This diversion of resources results in an opportunity cost, as the company is giving up the potential benefits of pursuing those alternative projects. Boeing produces ~800 aircraft annually (Boeing annual report), and the opportunity cost of producing one more commercial aircraft might be the loss of potential sales from not producing a military aircraft.

The opportunity cost of a decision can also be influenced by comparative advantage, a concept introduced by David Ricardo in 1817. According to Ricardo's comparative advantage model, countries should specialize in producing goods for which they have a lower opportunity cost, relative to other countries. For example, China has a comparative advantage in producing textiles due to its large supply of low-wage labor, which results in a lower opportunity cost of producing textiles compared to other countries. As a result, China has become one of the world's largest textile producers, with exports valued at over $100 billion annually (US Census Bureau).

The opportunity cost of a decision can also be affected by sunk costs, which are costs that have already been incurred and cannot be recovered. For example, a company like General Motors may have invested heavily in a particular project, but if the project is no longer viable, the sunk costs should not influence the decision to continue or abandon the project. Instead, the company should consider the opportunity cost of continuing to invest in the project, which may be higher than the potential benefits of completing it. General Motors has written off over $10 billion in sunk costs in recent years (GM annual report), demonstrating the importance of considering opportunity costs when making decisions.

Key Components

• Alternative uses of resources: The opportunity cost of a decision is determined by the alternative uses of the resources involved, such as labor, capital, or raw materials. When the alternative uses of resources are more valuable, the opportunity cost of the decision increases.
• Trade-offs: The opportunity cost of a decision involves trade-offs between different options, such as producing one product versus another. The trade-offs involved in a decision determine the opportunity cost of that decision.
• Comparative advantage: The opportunity cost of a decision can be influenced by comparative advantage, which determines the relative efficiency of different countries or companies in producing different goods.
• Sunk costs: The opportunity cost of a decision can be affected by sunk costs, which are costs that have already been incurred and cannot be recovered. Sunk costs should not influence the decision to continue or abandon a project.
• Marginal benefits: The opportunity cost of a decision is also influenced by the marginal benefits of the decision, which are the additional benefits gained from making that choice. When the marginal benefits of a decision are higher, the opportunity cost of that decision decreases.
• Opportunity cost of capital: The opportunity cost of capital refers to the return that could be earned by investing in an alternative project or investment. The opportunity cost of capital is an important consideration in making investment decisions, as it determines the minimum return required to justify an investment. Boeing's cost of capital is around 10% (Boeing annual report), which means that the company requires a return of at least 10% on its investments to justify them.

Common Misconceptions

Myth: Opportunity cost only applies to business decisions — Fact: Opportunity cost applies to all decisions, including personal decisions, such as choosing to spend time with family versus working overtime.

Myth: Sunk costs should influence decision-making — Fact: Sunk costs should not influence decision-making, as they are costs that have already been incurred and cannot be recovered.

Myth: Opportunity cost is only relevant in the short term — Fact: Opportunity cost is relevant in both the short term and the long term, as it determines the trade-offs involved in making decisions over time.

Myth: Opportunity cost is the same as marginal cost — Fact: Opportunity cost is not the same as marginal cost, although the two concepts are related. Marginal cost refers to the additional cost of producing one more unit of a good, while opportunity cost refers to the value of the next best alternative that is given up when a choice is made.

In Practice

When Ford decided to invest $11 billion in electric vehicle production (Ford press release), the company had to consider the opportunity cost of that decision, which involved diverting resources away from other potential projects, such as producing hybrid vehicles or investing in autonomous driving technology. The opportunity cost of Ford's decision to invest in electric vehicles is the potential benefits that the company could have gained from pursuing those alternative projects. However, Ford's investment in electric vehicles is expected to generate significant returns, with the global electric vehicle market projected to reach $1.4 trillion by 2027 (BloombergNEF). By considering the opportunity cost of its decision, Ford was able to make a more informed choice about how to allocate its resources and maximize its returns.