What Is Opportunity Cost And Why Does It Matter?
ByDaniel Kurt
The idea of scarcity lies at the heart of economics. It’s the concept that, in virtually every decision we make, we face constraints. In short, humans don’t have the money, skills, time – you name it – to get everything we possibly desire. Ergo, we have to make choices.
Economists are keen to remind us that decisions don’t take place in a vacuum. Life isn’t only about the choices we make, but the ones wecouldmake. This is where something called “opportunity cost” comes into play. It’s the term social scientists use to describe the value of the next best alternative to the option we’re considering. (Watch Investopedia's video onOpportunity Cost.)
While the phrase itself might sound like academic-speak at first, weactually evaluate opportunity costson a daily basis. Perhaps when you woke up today, you decided on a big bowl of cereal for breakfast, foregoing the opportunity to enjoy eggs and toast. A little later, you opt to take the train to work, sacrificing the benefits of driving your own car. It’s still early morning, and you’ve already decided on a series of small tradeoffs.
Now consider a slightly more consequential decision. Imagine someone gave you $100,000, which you aren’t planning to use for at least another year. Chances are you’re not going to put all that money into your free savings account that offers 0.05% annual interest. Why? Because you could choose to put it in a virtually risk-free certificate of deposit that pays, say, 0.5%.
Just because your bank account is “free” doesn’t mean that there’s no cost associated with parking your emergency fund there. You could receive $500 in interest by going with the CD, but would have to settle for $50 if you left the entire amount in the savings account. So your opportunity cost is $500. In economic terms, you’d be taking a loss if you didn’t invest the money in a more lucrative vehicle, assuming it’s no more risky than Option A.
Choosing how to allocate capital
Businesses also have to take opportunity costs into accountwhen making decisions, big and small. Let’s take an example with important implications: high-level budgeting.
Say that a fictitious manufacturer, Creatrix International, earned $50 million last year in net profit. The company has a number of options in terms of how to use that capital. It could invest in research and development to build a technological advantage over its competitors, hire additional sales staff or reward its shareholders with a generous dividend. Let’s assume that management wants to use all $50 million for just one of these three alternatives.
The Creatrix team conducts a thorough analysis of the first two options, which are the only two that have the potential to boost corporate earnings. It determined that an R&D investment would generate $60 million in gross revenue within five years. Adding to the sales team, however, would yield $80 million in new income.
Therefore, the opportunity cost of using the money for dividends is $80 million, the value of the next-best choice. Note that while augmenting R&D yields a $10 million accounting profit ($60 million minus $50 million investment), it’s not profitable from an economic perspective because there’s another alternative that represents a better use of those funds.
In the real world, companies make these decisions all the time. If the management team decides to increase dividends, it’s essentially saying that there’s no way they can use that money internally that would generate a bigger return than the dividend check itself. In other words, the opportunity cost is less than the value of the dividend.
Factoring in elusive benefits
Calculating opportunity costs may seem like a no-brainer when the only objective is to increase the bottom line. No successful company is going to reinvest its earnings without considering the financial effects of different options. Likewise, most individuals aren’t going to be happy simply because their savings increased over ten years – they’ll want to know how it performed versus other investment opportunities.
Yet, it’s also important to consider the value of alternatives when the benefits are harder to quantify. This is something that governments, in particular, have to do frequently.
Let’s say the small town of Bakersville has 50 acres of unused land along its serene lakefront. Commercial developers bring blueprints for an industrial park to the Bakersville planning commission. Their main pitch: the property would give the town $250,000 in additional property tax revenue.
Keep in mind that rubber-stamping the project wouldn’t cost the municipality much from an accounting standpoint. But it would leave residents without a beautiful, unobstructed view of the lake from a nearby highway. And some argue that it would change the feel of the community itself.
The opportunity cost, in this case, is the advantage of enjoying land in its natural state. Of course, no one can convert those benefits into precise financial terms. But ignoring the intangible consequences altogether would be putting their value at zero, which is a mistake. The town leaders have to make a rough calculation, if only by intuition, because they have to decide if a great view is worth $250,000.
The Bottom Line
Because of the scarcity of resources, saying “yes” to one option necessarily means saying “no” to the alternatives. To make the best decision, one has to consider the value of those other options, too.