Opportunity Cost Formula: The Best Next Alternative Value
.Opportunity cost is a theory in microeconomics that measures the value of two alternative choices to show what will be lost in the pursuit of one of these options. If microeconomics isn’t you’re thing try this course in micro and macro-economics for a refresher. To demonstrate the concept behind an opportunity cost, we’ll use the example of going to college after high-school versus going straight to work. On one hand, going to college means you either won’t have time to work, or you’ll work minimal hours and won’t make much money. If you decide to go straight to work you will be making much more money than you would in college. However, the time invested into getting an education is worth more than the money you would make otherwise. Once you have a degree you are more marketable to the global workforce which means you’re likely to make more money than you ever would if you didn’t get the education.
These two options each have their opportunity cost and thus allow us to understand the value of what we sacrifice, and what we produce, by selecting one or the other. The opportunity cost is actually considered the value of the next best alternative.
The basic formula for opportunity cost is:
what you are sacrificing / what you are gaining = the opportunity cost
Because there are so many variables to consider (explicit costs, time, job specialty etc.) when comparing going to college and going to work we are going to use a more simplified, yet perhaps less applicable, example. Assume you have the option between buying three laptops or, buying six video cameras. Your money is scarce so you have to choose between these two options. Let’s figure out the opportunity cost of choosing laptops over video cameras is. You are giving up 6 video cameras in exchange for 3 laptops. The equation looks like this:
6 video cameras / 3 laptops = 2 video cameras per laptop
This indicates that you sacrifice 2 video cameras for every laptop gained. Which means the opportunity cost of choosing laptops over video cameras is 2.
Now, let’s calculate the opportunity cost for choosing video cameras over laptops. We will use the same equation as above, except we put laptops in the “giving up” spot of the equation and video cameras in the “gaining” spot.
3 laptops / 6 video cameras = ½ laptops per video camera
So now we can place value on how much we can get for our money. We see that for every laptop we purchase, we’re getting two video cameras. This would be the best bang for our buck.
Now that you’ve acknowledged the opportunity cost of each option you can understand what you are giving up in the pursuit of another option. Learn how to master decisions in this Cognitive Biases course.
Making decisions can be overwhelming, especially when you are seemingly on the fence about the outcomes of choosing one path over another. In the course Creative Problem Solving you can learn tips to make decision-making easier. When I lived in Colorado I worked as a barista at a coffee shop for minimum wage ($8/hr). It was a good gig, but ready for change, I began to pursue freelancing. I assessed the amount of money I was made working at the coffee-shop and then compared to the money I would make pursuing a freelancing career (approximately $20/hr). The opportunity cost formula for choosing the barista job over freelancing looked like this:
what I sacrifice / what I gain = opportunity cost
$20 freelancing / $8 barista = $2.5 per hour
So, for every $1.00 I made at the coffee shop, I could be making $2.50 while freelancing. I then did the reverse equation. What is the opportunity cost for choosing freelancing over being a barista?
$8 barista / $20 freelancing = $0.40 per hour
So for every $1.00 I could make freelancing I was only making $0.40 for being a barista.
Of course, while looking for work I wasn’t going to be making any money but once I found work I knew that the amount I could make in addition to the benefits of making my own schedule and being able to travel were going to outweigh the value of my current meager wages. This was my own practical application of the opportunity cost theory. It worked. Find out how to become your own employer through freelance writing in this informative article: Freelance Copy-writing Career. When it comes managing economic decisions there are many methods you can use to make an educated choice. In the Chartered Economist course you can learn a general overview of managerial economic concepts to help you in your personal or business life.
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