Loading the player...

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.

RELATED TERMS
  1. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  2. Economic Profit (Or Loss)

    The difference between the revenue received from the sale of ...
  3. Foregone Earnings

    The difference in earnings or performance between what is actually ...
  4. Keystone XL Pipeline

    A proposed extension of the Keystone pipeline system that is ...
  5. Applied Cost

    A term used in cost accounting to denote the cost assigned to ...
  6. Unit Cost

    The cost incurred by a company to produce, store and sell one ...
Related Articles
  1. Investing

    TransCanada Sits In Oil Pipeline Catbird Seat

    TransCanada stands to win no matter what happens to the Keystone XL Pipeline. Approved? Send oil to a thirsty America. Shot down? Send it west to tankers.
  2. Insights

    What Is Opportunity Cost And Why Does It Matter?

    Economists suggest that the "opportunity cost" of any decision, the value of the next-best alternative, is crucial to making sound choices.
  3. Investing

    Keystone XL Rejected: Which Stocks Will Win, Lose?

    Are investors overestimating the Keystone XL Pipeline news? Here's a look at some of the stocks they're likely liking right now.
  4. Trading

    How To Trade Orange Juice Options

    How do orange juice options work and which factors determine the orange juice valuations? Here's a sneak peak into the world of orange juice options.
  5. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  6. Investing

    What Are The Different Types Of Costs In Cost Accounting?

    Cost accounting measures several different types of costs associated with a company’s production processes.
  7. Insights

    Invest In Yourself With A College Education

    Spending a few thousand dollars on school could help you earn millions more.
  8. Small Business

    How to Do a Cost-Benefit Analysis

    The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.
  9. Investing

    The Hidden Costs Of Investing In Mutual Funds

    Find the hidden fees in your portfolio, so that you can increase your rate of return.
  10. Investing

    Cost of Equity

    The cost of equity is the rate of return an investor requires from a stock before exploring other opportunities.
RELATED FAQS
  1. What is the difference between risk and opportunity cost?

    Learn the subtle differences between the concepts of risk and opportunity cost as well as how they impact your investment ... Read Answer >>
  2. What is the formula for calculating opportunity cost?

    Learn about the opportunity cost formula and how businesses use this calculation to decide between investment and capital ... Read Answer >>
  3. How does opportunity cost impact how cost of debt is evaluated?

    Learn about opportunity cost and how this concept is incorporated into the determination of the actual cost of debt capital ... Read Answer >>
  4. What is the difference between a sunk cost and an opportunity cost?

    Discover the difference between the sunk costs of an investment and the opportunity costs associated with the decision to ... Read Answer >>
  5. Why is President Obama hesitant to approve the Keystone XL Pipeline project?

    Find out how President Obama's hesitancy over the Keystone XL pipeline project is motivated by political pressure from two ... Read Answer >>
  6. What is the relationship between specialization of labor and opportunity cost?

    Learn the basic meaning of specialization of labor and opportunity cost, how they are applied in economic theory and the ... Read Answer >>
Hot Definitions
  1. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  2. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  3. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  4. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  5. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  6. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
Trading Center