Opportunity cost is often an aspect of life overlooked, largely due to the fact that it involves the impact that foregone events have on our lives.
For example, let’s say 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.
Let's figure out the cost not being considered below!
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
Determining explicit cost
Let’s start with determining what the explicit cost is for our ice cream shop vs. movies example. In this case, the explicit cost it’s going to be the alternative that we chose, which is going to the movies.
Explicit cost is the clearly defined dollar amount for the cost of the alternative that you choose.
How much do the movies cost? $20, so we’ll place $20 as our explicit cost.
Opportunity cost = $20 + implicit cost
Determining implicit cost
Next, let’s determine our implicit cost. Before doing so, let’s remind ourselves of how explicit cost factored into our example.
Explicit cost is the cost of the alternative that is chosen ($20 for the movies). This is the activity or the option that is done instead of the original option.
Implicit cost is the highest value of the forgone activity ($50 of income from work). In this case, by not going to work, you are losing out on $50 worth of revenue which is the implicit cost of going to the movies.
In other words...
Implicit cost is the highest value of the forgone activity.
Therefore, let's plug in $50 for our implicit cost.
Opportunity cost = $20 + $50
Interpreting opportunity cost
When we solve this out, we get an opportunity cost of $70.
Opportunity cost = $20 + $50 = $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!
The primary implication is in understanding the true cost of something. As humans, we typically focus on the accounting cost (explicit only)...
Accounting cost is the recorded, explicit cost of an activity.
...when in fact we should be focused on the economic cost (explicit + implicit).
Economic cost is the accounting cost + the opportunity cost. In other words, the explicit + implicit costs.
Opportunity cost is an essential factor when it comes to making economic decisions. As we progress through these concepts, we'll see this in action!