Opportunity Cost

Notes

• Opportunity costs represent the potential benefits you miss when choosing one alternative over another.

• You calculate using the formula:

where $OC$ is the opportunity cost, $FO$, the return on the best-foregone option, and $CO$, the return of the chosen option.

• Positive opportunity cost is bad because you lose the opportunity to earn more.

  • Example, you have choices A, B, and C with $B_a = 100$, $B_b = 80$, and $B_c = 50$ as their respective benefit. Considering you've chosen option B, your opportunity cost in this scenario is $100 - 80 = 20$. You've lost the opportunity to earn 20 more benefits.

• It's a microeconomic theory.

• It's a decision mental model because it helps you choose among options.

• It's difficult to calculate the exact cost of all options because some are unseen because of the implicit costs.

  • Implicit costs: these costs are hidden from the naked eye and aren't made known. They're not a direct cost to you. For instance, if you have a vacation home, the implicit cost is the rental income you could have generated if you leased it.
    • Implicit costs have significant potential. For example, if you start a company, you can make much more than the salary of a job.
  • Explicit costs are direct costs of an action executed through a cash transaction or a physical transfer of resources.

References

• Joshua Kennon. What Is Opportunity Cost?
• Wikipedia. Opportunity cost
• Jason Fernando. Opportunity Cost

Backlinks

• From Reactive Planning Model to Natural Planning Model