Microeconomic theory considers that time is finite, and it can be used to do different things. However, consumers are constrained by the fact that they can only do one thing at a time. Therefore, if we do one thing there is an implied cost of not doing the next best alternative. Opportunity costs matter since consumers have an array of choices and can change the mix of what they purchase.
Imagine an officer manager earning $100 per hour has the choice of working for an additional hour or going home to mow the lawn. He could employ a landscaper to cut the grass instead at a cost of $50. The manager would save money by employing the landscaper, but only he can make the decision over what the best use of his time is. After all, he can’t be in two places at once. The concept of opportunity cost helps explain the allocation of scarce resources.
Opportunity costs can be explicit or implicit. While in this example you can figure out the cost of employing someone to mow the lawn, there are other implied benefits. You may be better off taking a walk after work, clearing your head and enjoying life rather than working an extra hour of overtime. But you can’t put a price on the benefit you obtained from doing so. You just feel better for it, and probably less tired.
Scarcity forces individuals to make decisions or choices. Likewise, producers are faced with a scarcity of raw materials and labor as part of the production process. If time and all goods and services were infinite by nature, we wouldn’t have to allocate anything. It would all be abundant. What we sacrifice measures the opportunity cost of whatever we forego in order to consume something else that yields some benefit.
For their part, opportunity cost means that companies will choose between two competing projects and select the most beneficial one, whose actual benefits exceed the opportunity cost. In this way limited resources can be put to work with maximum efficiency.
You can see that opportunity costs are theoretical. You will not find them in a company’s income statement nor its balance sheet. But you might see how such theoretical positioning is relevant to decision-making and the allocation of scarce resources. Indeed, opportunity cost easily relates to Cost Benefit Analysis, which business decision-makers use to evaluate the viability of a project and to determine potential payoffs from one Project A over Project B. And while determining which project is preferable, Cost Benefit Analysis does not guarantee that a specific project will be profitable – just that it is preferable to the alternative.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.