How to Calculate Opportunity Cost

What is Opportunity Cost and How to Calculate It

If you've survived the theory part of opportunity cost, you must be wondering how to calculate opportunity cost. Well, all you need is to have the cost of your selected item and the cost of its next best alternative ready. Read ahead to know how you can use these two values to arrive at the opportunity cost figure.
Opportunity cost is a component of the collective concept of economic cost. In numerical terms, the opportunity cost value is nothing but the difference between the cost of the desired alternative and the cost of the next best alternative. Economic cost is collectively composed of total cost (fixed cost plus variable cost as they appear in cost accounting), average cost (average fixed cost plus average variable cost) and marginal cost, transaction cost, sunk cost and accounting costs besides opportunity cost. The concept of opportunity cost spans across four economic aspects - mutually exclusive economic alternatives, selected/desired alternative, next best alternative and the eventual decision to go for the selected alternative at the cost of losing the opportunity of the next best alternative. The phrase "at the cost of" holds the complete essence of the concept of opportunity cost. Let's look at the mathematical side of this concept and find out how to calculate this cost.

Calculating Opportunity Cost

Before we proceed towards the equation for calculation of total opportunity cost, let's take a quick look at the various aspects and components of this economic concept, the credit for the development of which is attributed to British philosopher, John Stuart Mill.

Mutually Exclusive Economic Alternatives are a group of choices of different utilities - goods, services, investment options, etc., that a person can choose from, usually with respect to though not necessarily, a common time frame or a particular amount of money. For example, a man having $20 can decide among buying a shirt, a cap, an audio CD or a baseball bat. However, he can decide upon just one of these, say, the shirt.

Selected/Desired Alternative is that article which the person finally opts for by giving up the opportunity to acquire the rest of the items. Extending the example given under the preceding point, the desired alternative would be the shirt as the man gave it priority over all other available alternatives and gave up on the opportunity to have any of the others in favor of the shirt.

Next Best Alternative is that article which the person would have settled for if he didn't get access to the selected or desired article. In the above example, the next best alternative could be any of the articles other than the shirt. However, only one object, and not all remaining objects, can take the place of the next best alternative. Therefore, in this case, the next best alternative can either be the cap, or the CD or the baseball bat but not all of them together. It's an or situation rather than an and one.

Eventual Decision is the choice that a person makes from among the available mutually exclusive articles to round in on the selected/desired alternative. This final decision is what determines which article gets the status of the selected alternative and what assumes the status of the next best alternative.

Opportunity Cost Equation

Check out the following equation, followed by an example illustrating the same.

Opportunity Cost = Cost of Selected Alternative - Cost of Next Best Alternative

Now let's see how we can evaluate opportunity cost using this equation.

Example: Nora currently needs to buy at least one among the three - a formal skirt ($50), a pair of earrings($70) and a patent leather purse($65) - but doesn't have enough money to buy all three. After much consideration, she decides to forgo the earrings and the purse and buy the skirt, though she wanted the earrings as well. Find out her opportunity cost if she buys the skirt.

Solution: Number of Economic Alternatives = 3 (skirt for $50, earrings for $70 and purse for $65)
Desired Alternative = $50 (skirt)
Next Best Alternative = $70 (earrings)

Now, applying the above mentioned opportunity cost formula:

Opportunity Cost = 50 - 70 = -20

Well, that explains how to generate the opportunity cost figure quite clearly and sets right any doubts regarding the numerical representation of this concept. As you must have discerned by now, this concept as well as the method of arriving at the mathematical figure for it is quite simple. Once the logic surrounding it is clear, grasping its essence hardly takes any effort.