Heavy duty technical theories making a practical appearance in daily life? Sounds so nightmarish! But it’s actually super interesting. While reading about this Economics theory in my senior secondary school days, I thought it’s just another interesting concept. But it was only after a few years did I realise that I had started applying this theory subconsciously in my day to day life decisions too! Which theory are we talking about? Opportunity Costs! The first theory that debunked the myth for me that bookish theories don’t apply practically. Time to uncover the logic behind the application of this Economics theory in both real life and business!
What is Opportunity Cost?
In the simplest of terms, it happens because you can’t have it all! When you choose an alternative, you have to give up certain other alternatives. The value of the closest or best alternative that you did NOT choose is the opportunity cost. That’s why it’s also known as alternative cost. You can also say it’s the potential benefits that you could have got from a foregone decision.
It’s super easy to understand it with an example, suppose you spent three hours watching a movie over the weekend. During the same time you were invited by your friends to play cricket. Since you made a choice of going to the theatre, then the opportunity cost here is the value you missed out on by not choosing to go and play the match with your friends! The benefit you missed out, is the alternative cost. You couldn’t choose both, because the time was limited.
Sometimes it’s easy to evaluate if a monetary or numeric value can be given to it or else it’s mostly a qualitative measurement.
A Few Things That Affect Opportunity Cost
1. If no clear monetary or numerical value can be given to it, it is prediction based.
2. It can vary from person to person.
3. It is highly dependent on priorities as well as income levels.
Most Unique Example of Opportunity Cost in Daily Life
How does a dream example sound? Imagine you just won a jackpot and received Rs. 7 crore (Complete KBC vibes!). You now have 2 top things in your bucket list. One was to buy a dream villa in a posh locality and the other was to buy a Rolls Royce car, both costing nearly the same. You can’t buy both as the funds are limited. The final decision you made was to go ahead and own that dream home.
What’s the opportunity cost here? No prizes for guessing, the potential happiness and satisfaction you would have got from owning a Rolls Royce is the opportunity cost!
Woah! Now that’s a sweet example, right?
P.S.: Would you have chosen a Rolls Royce car?
Another example? Time Management! Imagine you had 2 hours to spare on a Sunday. You could either read a book that will help you upskill or catch up on your favourite web series on Netflix. You chose to watch that awesome web series. The opportunity cost here is the knowledge you could have gained if you spent time working on upskilling. But still you might have taken the best decision, because happiness and relaxation was much needed and the opportunity cost was lower for the foregone benefit of reading that book! In short, this theory can help you in deciding what’s the best way to manage your time. Stay tuned for the next blog which is totally dedicated to finding the magic of logic on how opportunity cost helps with time management.
Opportunity Cost in Business Decision Making! How to Use it?
While scrolling through an entrepreneur’s video, I got super intrigued when he casually mentioned that he weighed in on a few options and chose the most favourable investment for his business based on this principle of opportunity cost! Like how was that possible? But when I delved deep into it, it actually made sense. Here’s how,
A Check on Profitability
Example time! Imagine you run a printed tees business. You now have two options, you could either launch a new collection or increase current stock of your latest bestsellers. Doing both isn’t possible because of inventory storage issues. If you choose option 1, you forecast a profit of average Rs. 50,000. The 2nd option can give you a profit of Rs. 90,000. Undoubtedly the decision is made as you choose option 2 because the opportunity cost is less!
Taking the decision that could be most profitable is the obvious choice!
Investment Decisions
No business has unlimited funds! Imagine you got Rs. 1 Crore (Wow!). You could either invest it in increasing the production capacity of your business or invest it in a mix of marketing strategy and hiring talented workforce. The correct decision is taken only when you choose the option that minimises your opportunity cost.
The Debt or Equity Dilemma
Remember watching Shark Tank episodes? Business owners either give up their equity or take up debt to get funds that help them grow their business. But how do they know which decision is correct for them? They calculate the opportunity cost!
Do Opportunity Costs Have Types As Well?
Oh Yes! Generally there are three: marginal opportunity costs, explicit and implicit opportunity costs.
These require a full story telling session of their own, but surely a blog is in works for it!
Math Time! Formula for Opportunity Cost
Not making it complex at all, the simplest formula for calculating opportunity cost is,
Opportunity Cost = Return on Best Alternative That was NOT Chosen – Return on the Chosen Opportunity
P.S.: If the return can’t be quantified it can get difficult to find an exact value for this!
Zero Opportunity Cost! Does it Exist?
You will be surprised to know that the answer is YES! It’s actually a very logical theory. If something costs you nothing, you are making no sacrifices and of course there is no scope of any alternative cost too! For example air, water, sunshine etc. are free because they are in abundance, thus there is no need for alternatives and no opportunity cost too.
SImilarly there is a possibility that you are indifferent between two decisions or there is no alternative to a decision. In this case too the opportunity cost is zero.
Fun Fact: Being born also comes under the category of zero opportunity cost because there is no alternative to it!
Wow! Opportunity cost theory definitely applies to so many practical scenarios. Application of economics theories in daily lives is actually a reality! As I was curating this blog, I realised how much more this theory needs to be discovered, especially how well it blends into every business decision, right from pricing decisions like formulating discounts to even complicated management decisions. Will surely try to share more about my knowledge gained related to the amazing opportunity cost theory. Till then, do share which part came as a surprise to you related to this theory. Would love to read your views in the comment section below.