Opportunity Cost: Definition, Calculations & Examples

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  • 0:05 Cost of Everything
  • 2:23 Different Opportunity Costs
  • 4:21 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

This lesson discusses opportunity costs, a central idea of economics. In addition to examining the general idea of opportunity costs, it also looks at the role of explicit and implicit costs to firms.

Cost of Everything

Because everything is scarce, that means that nothing is free. It might be really cheap, like air, or it might be really expensive, like a diamond ring, but everything has a price. This is because in the amount of time it takes us to use, experience, or acquire something, we could have been doing something else.

Time is a great example of how we pay for things. By watching this lesson, you are giving up time that you could be using doing something else. No doubt, some of those things are more enjoyable than this lesson. However, you chose to do this lesson because it has the greatest utility, or use to you at a given time.

Forget dollars, Euros, or pounds, utility is the currency of the economic world. We decide to do something because it gives us the greatest utility. You are studying right now because an understanding of economics, at this given time, is more important to you than something else, like watching reality TV. Note that I did not say that it was necessarily more enjoyable, but simply has greater utility.

In fact, that leads us to our next term. The cost of doing something, like studying, in terms of whatever you gave up to do it is the opportunity cost. The opportunity cost of an hour spent studying economics is two episodes of your favorite TV show, or an hour spent playing video games, or any other way you could think of spending the time it takes you to study.

To calculate the opportunity cost of a given good, simply look at what it costs you in terms of doing something else. Watching late-night TV costs you two hours of sleep. Spending too much time on a video game costs you a good grade on a quiz. Buying new shoes meant that you couldn't buy a new handbag. Whatever it is, the opportunity cost is calculated by looking at the next activity on your list of preferences. That is important - just use the one that you'd rather be doing, because you can't do them all. I would love to be able to work, cook, and sleep all at the same time, but I can't. In fact, I probably shouldn't even try.

Different Opportunity Costs

Of course, opportunity costs come in different varieties. The two most important of these are explicit and implicit costs. Explicit costs are often the easier of the two to calculate, because these are costs that involve the company spending money. A firm may have a million dollars available but is faced with the opportunity to increase advertising or pay down debt. Both cost a million dollars, but one would probably have greater utility for the firm than the other. If the firm needs to sell more goods, they would likely choose to increase advertising. Thus, the explicit opportunity cost is the amount that they could have spent paying down debt.

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