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Opportunity Cost

Imagine you work at the local ice cream shop. You’ve got a night shift for 5 hours, which at your going rate of $10/hour, would result in $50 of income.

However… your crush on wants to go to the movies with you tonight. The movie tickets are going to cost you $20.

At first glance, you might think skipping out on work and going to the movies is just going to cost you $20 for the tickets. However… There's another cost not being considered here.

Opportunity cost is the loss of potential gain from other alternatives (ex: going to work) when one alternative (ex: going to the movies) is chosen.

How to calculate opportunity cost

Let’s start with the formula for opportunity cost, and then break it down from there:

Opportunity Cost = Explicit Cost + Implicit Cost 

Explicit cost is the clearly defined dollar amount for the cost of the alternative that you choose.

In this case, the alternative we chose was going to the movies.

How much do the movies cost? $20, so we’ll place $20 as our explicit cost.

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + Implicit Cost

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + Implicit Cost

Implicit cost is the highest value of the forgone activity.

By not going to work (a.k.a. the "forgone activity"), you are losing out on $50 worth of revenue which is the implicit cost of going to the movies. 

Therefore, let's plug in $50 for our implicit cost.

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + $50

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + $50

When we solve, we get an opportunity cost of $70.

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + $50
Opportunity Cost = $70

This indicates to us that the true cost of going to the movies instead of working at the ice cream shop is actually $70!

Opportunity Cost = Explicit Cost + Implicit Cost 
Opportunity Cost = $20 + $50
Opportunity Cost = $70

Accounting vs. Economic costs

As humans, we typically focus on the accounting cost (explicit only)...

Accounting cost is the explicit cost of an activity.

...when in fact we should be focused on the economic cost (explicit + implicit)...

Economic cost is the accounting + opportunity cost. In other words, the explicit + implicit costs.

...as this represents the true cost of something.