What is Opportunity Cost? [Concept and Definition]

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Have you ever heard about opportunity cost? In financial terms, this is also sometimes called the Alternative Cost. The concept was coined more than a century ago by Friedrich Von Wieser in his famous book ‘Theory of Social Economics,’ published in 1914.

In it, Von Wieser talks about opportunity cost as the cost of investing available resources at the cost of the best alternative investment available, in other words, he talks about the value of the next-best option that is ultimately not performed.

One of the main points of opportunity cost is to provide the client, whether it is this investor or entrepreneur, the necessary information that will make them realize why they should choose one alternative over another.

Within this theme, there are certain relevant aspects that it is important to take into account to explore the opportunity cost, both in theory and in practice.

Do you want to know more about this topic? Continue reading!

Opportunity cost types

The opportunity cost is an issue that is fundamental for making financial decisions, especially investment, since it is the discarded value that derives from completing an operation or not carrying it out.

This term is measured by the profitability that is expected to be obtained through investment funds, that is, the performance.

Different types of opportunity cost can be found, such as:

  1. Implicit opportunity cost: these are directly related to the alternative profit options or the money that an investor stops receiving when he decides to carry out certain commercial movements. Among the implicit costs that a company may incur are: the use of equity capital, whether in money or assets, or the use of individual financial resources. The implied opportunity cost does not involve direct payment or transaction, which means that no transfer is made to third parties.
  2. Increasing opportunity cost: In this case, the opportunity cost requires the renunciation of larger quantities of an alternative good, and it occurs when the resources are not equitably productive. In general, increasing opportunity costs occur when there are no homogeneous resources, so they tend to be inefficient over time.
  3. Constant opportunity cost: To refer to these, the term “Ricardian costs” is also used; These occur when resources or factors can be substituted for each other without any impediment, or when all units of the same factor are equal to each other or exactly the same quality is found in them. In practice, constant costs are not believed to represent a realistic scenario due to its straight line production line.
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How Opportunity Cost Works

Calculating the opportunity cost is a process that does not require complicated formulas, but rather the analysis of all the available data regarding investment alternatives, return on investment and everything related to these operations.

To calculate the opportunity cost, it is necessary to resort to a simple formula, by means of which the possible scenarios of the investor and the potential result of their decision-making are considered.

The formula to follow is:

Opportunity Cost = FO − CO

Where:

FO refers to the return on the best option not chosen

CO refers to the return on the selected option

Steps to calculate opportunity cost

Here are some steps to take into account when calculating the opportunity cost

  • Identify all scenarios and options:

The first step is to identify all possible scenarios and options; The main objective of any calculation related to the opportunity cost is to extract the maximum benefit for the investor or the company involved in the process. Thus, it will be essential to identify all the scenarios and options that can be given in the decision-making of those involved.

  • Calculate the expenses of each option:

Knowing in depth each option that is available will allow knowing the cost or real price of each of them, which will lead to a calculation attached to reality, so that any decision made from it will guarantee a successful operation .

  • Calculate the return on each investment:

It is not enough to know that benefits will be obtained: it is necessary to identify what they will be and what amounts will result from each investment or movement financial, in the short, medium and long term.

  • Choose the most beneficial option:

Although the formula established to determine the opportunity cost is reliable, there are other factors that can influence the profits that will be obtained through an investment, so, in the end, all the people involved in said decision making must choose the most beneficial option for the investor or the company.

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Opportunity cost examples

Here are some examples of opportunity cost so that you can see how they are calculated and what are the factors that intervene in them.

  1. Take as an example the case of a person who has made the decision to invest their savings, for which they go to a banking institution, where they offer to take a fixed term, where the interest rate will be 10%; however, you also have the option of investing in bonds with an interest rate of 15%. Finally, the person decides on the first option, which means that their opportunity cost will be 15%, derived from the profits that they will lose by refraining from investing in the bonds.
  2. On the other hand, an opportunity cost can also be calculated in other types of operations; for example, in the case of people who have properties that they do not intend to sell, rent or live in. Thus, if at a certain moment the person finds himself in the position of deciding whether to rent his house, say for $ 2000 per month, this figure will be his opportunity cost in case of not renting the property. (Source: encyclopediaeconomica.com)

FAQs

Undoubtedly, the opportunity cost is a concept that aims to ensure that any investor makes decisions that achieve maximum benefit; however, there are some data that are especially relevant to learn more about how it works:

What is the basic idea of ​​opportunity cost?

The basic idea of ​​the opportunity cost is to find the best alternative, which is why it is also known as the alternative cost, and its basis is focused on the analysis of the risks and benefits derived from one investment over another.

One of the main points of opportunity cost is to provide the client, whether it is this investor or entrepreneur, the necessary information that will make them realize why they should choose one alternative over another.

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Which definition best describes opportunity cost?

The concept of opportunity cost is very present in the economic sphere, and one of the most commonly used definitions to refer to opportunity cost is the search for a potential benefit that an investor loses when choosing a different option. .

The concept was coined more than a century ago by Friedrich Von Wieser in his famous book ‘Theory of the Social Economy’, published in 1914.

In it, Von Wieser talks about the opportunity cost as the cost of investing the resources that are available at the cost of the best alternative investment available, in other words, he talks about the value of the best option that is ultimately not performed.

What is opportunity cost class 11?

The opportunity cost classes are:

  1. Increasing opportunity cost: In this case, the opportunity cost requires the renunciation of larger quantities of an alternative good, and it occurs when the resources are not equitably productive. In general, increasing opportunity costs occur when there are no homogeneous resources, so they tend to be inefficient over time.
  2. Constant opportunity cost: To refer to these, the term “Ricardian costs” is also used; These occur when resources or factors can be substituted for each other without any impediment, or when all units of the same factor are equal to each other or exactly the same quality is found in them. In practice, constant costs are not believed to represent a realistic scenario due to its straight line production line.
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conclusion

The opportunity cost is a concept that aims to guide people, regardless of the field in which they work, to make sound financial decisions according to their personal or business projects.

By knowing the market in depth and defining what the potential gains or losses would be when favoring one operation over another, investors are in a position to make better decisions that allow them to generate profits in the short, medium and long term in any of their projects. , from going to the movies to buying or renting a property or investing in bonds or fixed terms.

 

Source: Investopedia.com / Amosweb.com / encyclopediaeconomica.com

The post What is the Opportunity Cost? [Concepto y Definicion] appeared first on Hispanic World.

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