In this article, we will learn more about examples, formula, explicit cost, implicit cost, and concept of opportunity cost in managerial economics. Businesses often establish a minimum internal rate of return, or IRR, based on historical and future opportunity costs. The concept of opportunity cost helps individuals and businesses understand the potential outcomes they forego when making a decision. Understanding opportunity cost can help you make better decisions. When you fully understand the potential costs and benefits of each option you’re weighing, you can make a more informed decision and be better prepared for any consequences of your choice. Another example of opportunity cost is something as simple as choosing between going to work and skipping work.
Without this careful weighing of the options, you may find your portfolio filled with easily outperformed assets. The concept of marginal cost in economics is the incremental cost of each new product produced for the entire product line. For example, if you build a plane, it costs a lot of money, but when you build the 100th plane, the cost will be much lower. When building a new aircraft, the materials used may be more useful, so make as many aircraft as possible from as few materials as possible to increase the margin of profit. Despite the fact that sunk costs should be ignored when making future decisions, people sometimes make the mistake of thinking sunk cost matters.
What is Marginal Opportunity Cost?
Decisions typically involve trade-offs, and understanding opportunity cost helps ensure that resources are allocated most efficiently. They’re not direct costs to you but rather the lost opportunity to generate income through your resources. On a basic level, opportunity cost is a common-sense concept that economists and investors like to explore. For example, what would have happened if Walt Disney had never started animating?
Opportunity cost can be used to inform any decision, from investing in a security to what leisure activities one does during their free time. Therefore, a positive net present value suggests funds invested in this opportunity provide a return greater than if the funds were invested elsewhere. Future estimated cash flows are discounted by a company’s IRR to calculate the net present value of an investment. Company ChooseRight assesses an investment in a $100,000 machine that will net a profit of $150,000 over its useful lifetime of 10 years. When someone decides to buy a luxury item instead of saving, the opportunity cost could be the potential compound interest earned over the years. Every dollar spent today could have been saved or invested for a potentially higher value in the future.
Application of Opportunity Cost
If you enter the workforce at 16 without qualifications you start earning money straight away. But the opportunity cost is that you lose out on the potential of getting better qualifications and possibly a higher salary in the long-run. If you have 12 hours at your disposal during the day, you could spend these hours in work or leisure. The opportunity cost of spending all day watching TV is that you are not able to do any study during the day.
- While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can’t be assigned a dollar amount.
- This comparison doesn’t just consider the immediate benefits but also looks at long-term outcomes and potential missed opportunities.
- Prior to a 2016 peace agreement, Colombia had government instability and a decades long guerrilla war led by the Revolutionary Armed Forces of Colombia, or FARC, and other minor groups.
- Write down concepts clearly before moving over them so that there won’t be any difficulty while practicing later on during exam time!
- Johnson points to historical data on stocks versus bonds to illustrate the missed financial opportunities.
The concept of opportunity cost has a very wide application in economic theory and policy. The concept of cost of production is very significant in economics because it influences the production, supply, sales and the determination of price in the market. Economic profit, however, includes opportunity cost as an expense. This theoretical calculation can then be used to compare the actual profit of the company to what its profit might have been had it made different decisions. Explicit costs are as the name suggests direct costs that can be identified clearly. The explicit costs are incurred and recorded in the books of accounts.