What is an 'Opportunity Cost'
An opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is therefore most relevant for two mutually exclusive events, whereby choosing one event, a person cannot choose the other.
BREAKING DOWN 'Opportunity Cost'
Using a simple example, if a farmer is able to pick five apples from an apple tree or five oranges from an orange tree but cannot pick both, he faces a mutually exclusive event. Then, if he decides to pick the apples, his opportunity cost is the five oranges he cannot pick. Using another example, if a gardener decides to grow carrots, his opportunity cost is the alternative crop he could have grown instead.
Opportunity Costs in Finance and Money
In finance, opportunity costs are used to measure the differences in returns between a chosen investment and one that is forgone. For example, consider a person who invests in a stock that returns a paltry 2% over the year. By placing his money in the stock, the investor gives up the opportunity to invest in another investment, such as a risk-free government bond yielding 6%. In this situation, the opportunity cost is 4%, or 6% - 2%.
Opportunity cost also extends to personal finance. The opportunity cost of going to college is the money a person would have earned if he had worked instead. A person loses four years of salary while getting a degree; however, he hopes to earn more during his entire career, thanks to the education, to offset the lost wages. The opportunity cost of not going to college could also be a reduction of earnings over the long term. In both cases, a choice between two options must be made. It would be an easy decision if the end outcome was known; however, the risk of achieving greater benefits with another option is the opportunity cost.
A Real World Example of Opportunity Cost
In November 2015, President Barack Obama staunchly opposed TransCanada Corporation’s Keystone XL oil pipeline on the grounds it would negatively affect climate change. However, both TransCanada and Alberta, the location of the pipeline, did not agree with President Obama, citing opportunity costs that included lost revenues for TransCanada and an inability for Canada’s oil sands producers to capture higher prices for crude oil production. In this scenario, the opportunity cost of stopping the pipeline from continuing is lost income for Canadian companies, which also affects the Canadian economy.