Opportunity cost is the value of the next best alternative you give up when making a decision. It is one of the most important concepts in economics and everyday financial decision-making.
The Basic Formula
Opportunity cost = Value of next best option − Value of chosen option
If you choose the better option, opportunity cost can be zero or negative. If you choose wrongly, it's positive (you gave up more than you got).
Simple Example: Time
You have a Saturday free. Your options:
- Option A: Work overtime: earn £120
- Option B (chosen): Go to a concert: enjoyment valued at £80
Opportunity cost = £120 − £80 = £40
Going to the concert cost you £40 in opportunity cost (not monetary cost, but the value foregone).
Financial Example: Investment Allocation
You have £20,000 to invest. Your options:
| Option | Expected return (p.a.) | Annual gain |
|---|---|---|
| Savings account | 4% | £800 |
| Index fund (chosen) | 8% | £1,600 |
| Property | 6% | £1,200 |
| Bonds | 3% | £600 |
You choose the index fund. The next best was property:
Opportunity cost = £1,200 (property) − £1,600 (index fund) = −£400
Negative opportunity cost means you made the better choice.
Business Example: Using a Building
A business owns a warehouse it uses for storage. What is the opportunity cost?
- They could rent it to another company for £25,000/year
- Their storage is valued at £10,000/year
- Opportunity cost of using the building themselves: £15,000/year
This is also called implicit cost — the value of owner-provided resources.
Explicit vs Implicit Costs
| Type | Example |
|---|---|
| Explicit cost | Cash paid — rent, wages, materials |
| Implicit cost | Opportunity cost — foregone salary, investment return |
| Economic cost | Explicit + Implicit |
Economic profit subtracts both, while accounting profit only subtracts explicit costs.
The Trade-Off Concept: Production Possibility Frontier
A factory can produce:
- 100 units of Product A and 0 of Product B
- 0 units of A and 80 units of B
- 60 A and 40 B
Every unit of A produced has an opportunity cost in units of B foregone. As more A is produced, the opportunity cost typically rises (law of increasing opportunity cost).
Everyday Applications
- Education: University cost is tuition plus 3–4 years of foregone salary
- Home ownership: The deposit tied up in a house has an opportunity cost (investment returns foregone)
- Time: Any time spent on one activity cannot be spent on another
- Holding cash: Cash loses value to inflation — the opportunity cost is the real return on invested assets