Welcome to a new series introduced to the page called The ABCs of Economics, where I take basic concepts taught in Economics and try to explain them in a more understandable and detailed method, along with providing instances of how they’re used in day to day life.
The first topic for the series is going to be Opportunity Cost, also known as Alternative Cost or Opportunity Cost of Capital. It is arguably one of the most fundamental concepts in Economics and is a necessary theory to get a grasp of.
Opportunity Cost, originally introduced by Friedrich von Wieser (picture above) in his book Theorie der gesellschaftlichen Wirtschaft (Social Economics), refers to the cost incurred by the user by not using the next best alternative. This cost is different than the one you may read about in financial statements or in day to day services as these costs are generally referred to as Sunk Costs (also sometimes interpreted as explicit costs), implying that the money has been spent (sunk) and is irrecoverable. It is crucial to understand the differences attributed to these two concepts, and this is best done through a simple example.
Suppose Company A decides to invest 5,00,000 dollars in a new manufacturing space, designed for improving the products sold by A. These 5,00,000 dollars will be referred to as a Sunk Cost, since A has already spent the money on the supplies, and it is now irrecoverable. In a year, this option will drastically cut the expenses on making the product and hence earn Company A a revenue of 5,20,000 dollars, after the which the manufacturing space will be unusable, thus earning company A a profit of 20,000 dollars.
Suppose now instead that Company A had 2 options, the first being to invest in the new manufacturing plant and the second being to simply place the money in the bank and earn an interest of say 5% on it. In a year this would earn Company A a revenue of 5,25,000 (105% of 5,00,000). Thus, the company would have earned a profit of 25,000 by investing the money in the bank.
To Calculate the Opportunity Cost, we subtract the Profit from the manufacturing space and the profit from the money invested in the bank to get = 5000 dollars. Thus, if the manager had given more thought to the opportunity cost of the project, they would have noticed the better solution and would have made an increased profit.
While Opportunity Cost might seem like a foreign concept, there are many everyday uses of it, both in Financial Services and outside.
· In terms of Financial Services, a simple method used by most investors is to compare a risky investment in an asset (for example a stock) to the least risky asset available. For example, when for an investor situated in the United States, he will often compare his expected ROE (Return on Equity) with the interest available on a U.S. Treasury Bond.
Note- This comparison between stock and bonds is often a reason why we see interest rates and dividend rates in stocks and bonds moving in alternate directions.
· Opportunity Cost also has many implications on our day to day lives as well. It is important to remember that Economics is a Social Science and hence, while it has immeasurable implications for Financial Analysis, is primarily designed to study society and us as people. Inherently, people use the concept of opportunity cost all the time in our day to day lives. When a student is in a Math lesson and wonders what video games he could be playing, he is examining his Opportunity Cost for his utility in that hour, when you make the decision to buy a car, you are examining the cost of buying the car and the benefits of all the time it saves you compares to the next best alternative which would be different forms of public transport.
A noteworthy issue on Opportunity Cost to focus on would be the absence of a unit. While we mention it is the cost of not using the next best alternative, we might not always know what the next best alternative use is. A common issue encountered by most Economists is how to quantify the Opportunity Cost for an average individual. While the go-to method is to use the average amount of money earned per hour as a substitute for the next best alternative, various psychologists have challenged the effectiveness of this claim, stating not all individuals would be working all the time.
Hopefully, through the use of examples and practical uses, you have gained a better understanding of how Opportunity Cost is utilized by different members of the economy and its validity in being used as a method of comparison, both in investment decisions as well as in behaviour itself.