Opportunity Cost Meaning
Opportunity cost is the benefit foregone or loss of value that is incurred when one alternative is chosen over the other.
Mathematically, opportunity cost is the difference between the expected return from option foregone and the expected return from the option chosen. Looking at opportunity costs, might help you make better investment or employment decisions. This is because, if this difference is positive, it means the option foregone was more lucrative than the option chosen.
Opportunity Cost Example
Taking an example, say you have two options. Option A is to spend the next hour reading articles on this blog and option B is to sleep for an hour. Now say you chose Option A, that is to read this blog. If your utility derived from reading the blog is 100 units and that from sleeping is 120 units, then your opportunity cost of reading this blog is 120-100 units that is 20 units. Implying you would have gained more utility from having slept the next hour, rather than reading this blog.
More technically, opportunity cost reflects the relationship between scarcity and choice. Because of scarcity of time or money there is a limitation to what one can do.
Components of Opportunity Cost
When we talk about opportunity cost, both implicit and explicit costs are considered. Explicit cost are direct and measurable where as implicit costs notional and implied. If you have to chose between two employment options, some of the factors that you might consider are annual salary, performance bonus, quality of work and work life balance. In this example, the first two are measurable and are considered as explicit costs where as the other two are notional and thus implicit costs.
Often Sunk Cost is confused with opportunity cost. However, the two differ from each other. Sunk cost is the money that has already been spent in the past and cannot be regained. Opportunity cost on the other hand, is the choice between two alternatives that one makes with that money.