Concept 2: Opportunity Costs

Beginner

Opportunity cost is closely related to the concept of scarcity, explained in Concept 1. Since people, businesses and governments cannot get everything they want, they must make choices. With each choice comes a cost or a missed opportunity. The opportunity cost of a choice is the next best alternative given up. For example, assume a person is choosing between pancakes and waffles for breakfast. If they choose pancakes, the enjoyment of eating waffles is the opportunity cost. It was the next best alternative (2^nd choice) that was not selected. If a restaurant chooses to close for a day to train employees on a new computer system, the opportunity cost is the revenue the restaurant would have earned that day.

Intermediate

In real life, we often have more than two solutions to any given problem. Opportunity cost specifically refers to the next best alternative -- not all other alternatives. Imagine you are at a food court or the food section at the state fair, where there are six food stands, and you are hungry for lunch.

You only have enough money for one meal. You do not have the ability to eat at all six food stands (nor would you, probably, even if you had plenty of money). More likely you will choose one -- let’s say, pizza. Once your choice is made, your opportunity cost is ONLY your second best option, the food stand you would have chosen next. It is incorrect to say that the opportunity cost of choosing pizza was all of the other food stands. Preference and rank order are important concepts when thinking about opportunity cost.

Advanced

Opportunity costs are time sensitive and specific to each individual. In the beginner reading, for example, giving up waffles for pancakes is only the opportunity cost for that person in that moment in time. The next day the choice may be between pancakes and cereal or pancakes and no breakfast at all. As individuals age and transition through life, costs change. The opportunity cost of coming to school for high school-age children is fairly low. The alternatives they sacrifice to come to school (extra sleep, video games, low-wage employment, etc.) are generally low cost and low long-term benefit. The opportunity cost of a successful, high profile attorney going back to school is significantly higher. Understanding opportunity costs is critical to understanding rational decision-making.