Opportunity cost can be defined as the cost of an alternative which must be abstained from so as to pursue a specific action. In other words, opportunity cost refers to the benefits that could have been received through an alternative action.
Explaining opportunity cost
As explained by Investopedia, the opportunity cost can be explained through the following illustration. The opportunity cost of going to college is the amount that could have been earned through working instead. Where on one hand you miss four years of salary while earning a degree, on the other hand, you also expect earning much more during your career.
Taking another instance, if a gardener decides to grow potatoes in his field, his/her opportunity cost would be the alternative crop that could be grown otherwise.
Both the aforesaid cases involve making a choice between the two options. The decision would have been easier if the end outcome was known.
Significance of opportunity cost
Analyzing the opportunity cost forms an essential part of a business firm’s decision making processes. Besides, it is an imperative economic concept which finds application in wide ranging business decisions. Also, opportunity costs are real although they do not appear on the balance sheet.
The opportunity cost might feature significant value although it doesn’t have a specific monetary value. Moreover, the decision taking authority must subjectively estimate t6he opportunity costs. The opportunity costs are difficult to be quantified for being frequently related to future events. However, opportunity costs are very often overlooked while making decisions. Besides, the opportunity costs might also include the peace of mind for the investor who has invested in a professionally supervised fund.
Also, opportunity cost evaluation features various practical business applications, for opportunity costs will subsist with subsisting resource scarcity. While choosing from different production possibilities, evaluating the cost of capital, analyzing comparative advantages, and even while making a choice for the product to buy or how time should be spent, it is highly important to consider the value of next best alternative.
Therefore, it is essentially important to consider all feasible costs while making economic decisions rather than considering only those which can be concretely measured in dollars and return rates.