Opportunity cost
In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would have been had by taking the second best available choice.[1] The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". As a representation of the relationship between scarcity and choice,[2] the objective of opportunity cost is to ensure efficient use of scarce resources.[3] It incorporates all associated costs of a decision, both explicit and implicit.[4] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure, or any other benefit that provides utility should also be considered an opportunity cost.
Types of opportunity costs[edit]
Explicit costs[edit]
Explicit costs are the direct costs of an action (business operating costs or expenses), executed through either a cash transaction or a physical transfer of resources.[4] In other words, explicit opportunity costs are the out-of-pocket costs of a firm, that are easily identifiable.[5] This means explicit costs will always have a dollar value and involve a transfer of money, e.g. paying employees.[6] With this said, these particular costs can easily be identified under the expenses of a firm's income statement and balance sheet to represent all the cash outflows of a firm.[7][6]
Examples are as follows:[5][8]
Use of opportunity cost[edit]
Economic profit versus accounting profit[edit]
The main objective of accounting profits is to give an account of a company's fiscal performance, typically reported on in quarters and annually. As such, accounting principles focus on tangible and measurable factors associated with operating a business such as wages and rent, and thus, do not "infer anything about relative economic profitability".[14] Opportunity costs are not considered in accounting profits as they have no purpose in this regard.
The purpose of calculating economic profits (and thus, opportunity costs) is to aid in better business decision-making through the inclusion of opportunity costs. In this way, a business can evaluate whether its decision and the allocation of its resources is cost-effective or not and whether resources should be reallocated.[15]