Understanding opportunity cost
Because resources are scarce, every economic decision involves a trade-off. Opportunity cost is the value of the next best alternative that is sacrificed when a choice is made. For example, if a government spends money on building a new road, the opportunity cost may be the hospital or school that could have been built with the same funds. Opportunity cost applies to individuals, firms and governments whenever they allocate resources.
Easy definition
The true cost of a choice is not just the money spent. It is also the next best alternative that you give up.
Opportunity cost helps explain why choices must be prioritised. It highlights that the true cost of any decision is not simply the money spent but the benefits of the alternative forgone. This is why economics always involves comparing alternatives before making a decision.
Student example
If a student chooses to study Economics instead of another subject, the opportunity cost is the knowledge and qualifications from the subject not chosen.
Firm example
If a firm invests money in new machinery, the opportunity cost is the other use of that money, such as advertising or saving it.
Government example
If a government builds a highway, the opportunity cost may be the schools, hospitals or housing it could have funded instead.
| Decision | Alternative forgone (opportunity cost) |
|---|---|
| A student chooses to study Economics instead of another subject | The knowledge and qualifications from the alternative subject |
| A firm invests in new machinery | The profits it might have earned by investing the funds elsewhere |
| A government builds a highway | The public housing or hospitals that could have been built with the same funds |
| A person takes a year off work to travel | The wages they would have earned by working during that year |
Thinking about opportunity cost allows economists to evaluate whether the benefits of a decision outweigh the costs. Decisions with lower opportunity costs are generally preferred.
