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Opportunity Cost

Opportunity Cost

Author: Kate Eskra

This lesson will explain Opportunity Cost

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Video Transcription

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Hi. Welcome to Economics. This is Kate. This tutorial is on Opportunity Cost. As always, my key terms are in red, and my examples are in green. So in this tutorial, we'll simply be defining opportunity costs. And I'll help you to understand how they are used in assessing investor returns or business profits.

So we're going be thinking both like a business and an investor for a couple of minutes here. So obviously, the point of doing either of those things is to make some sort of profit, right? For a business, remember that their profit equals their revenues or their sales, minus their costs, whatever it took them to produce their product. OK.

So let's start with businesses. Firms have to make strategic decisions all of the time. They have to consider what to produce. And they have to consider what technologies to use, or whether to hire more labor, or more capital, et cetera. The key idea is that whatever they decide, they're always sacrificing something else. Whenever you make a decision to do something, you're giving up something. They are, as well.

So if in the decision to produce something they have product A or product B, and they decide to focus their attention on products A, they're sacrificing the ability to produce product B. And they're also sacrificing the potential returns that that product could have given them. Same goes for technology. If they choose one technology over another, they're giving up the ability to implement that other, that next best technology. OK.

So when you're investing, you're looking at which company is going to yield a better return. I put here, safe versus risky investment, because I am very safe with my money when it comes to investing. I'd rather keep my money in the bank, or keep it in a really, really safe kind of low interest bond that I know I'm not going to lose it.

If I decide to take my money out of that safe investment and instead invest it in kind of a risky business venture, let's say, I'm sacrificing that very safe return that I could've made on that. So any time an investor is looking at a decision, they're sacrificing the return that could have been made on their next best option.

Why this is important to talk about here is because these are opportunity costs. And opportunity costs are the sacrifice made by choosing one value or opportunity over another. And they're really important in economics, because they're going to help us decide whether we made a good decision or not. OK.

If we look just at an accounting profit, it's more straightforward. It's just total revenue, which is price times quantity, minus our total cost, which is the cost per unit times quantity. But here, these are just explicit costs. They're out of pocket costs. OK. In economics, we take this a step further, and we say that economic profit is our total revenue minus all of our costs. And all of our costs include some of those examples that I was talking about before, our opportunity costs.

So this doesn't just include your cost of purchasing your labor, so paying your employees, and paying for your raw materials, it's going to also include what you're sacrificing, or what you're giving up. If we're talking about, let's say, my example of taking my money out of a safe investment and going into a more risky investment, what I'm giving up the opportunity to do is earn that very safe return. OK?

Another example would be, a lot of times people will quit their job to start a business. And in evaluating whether it's profitable or not, an economist says, well, we have to measure the foregone salary, you know, your salary that you just gave up in order to start this new business. Those things are not included in just a straightforward accounting profit, but they are very much considered in economic profit, because they represent what we gave up, or opportunity costs.

So in this tutorial we talked about how firms and investors make strategic decisions, which always include an opportunity cost, that next best thing that was sacrificed. Economists consider all of these costs, including opportunity costs, when evaluating whether decision was profitable or not. Thanks so much for listening. Have a great day.

Terms to Know
Opportunity Cost

The sacrifice made by choosing one value or opportunity over another.