Opportunity Cost: Why It Has High Importance In Economics & Finance?

By: Prakriti Nepal

Opportunity cost is the cost that crops up, if you miss out on performing certain activities, that might have given you any kind of benefits or any losses. If you wake up at 5:00 AM for purposeful morning activities, then your opportunity cost might be – missing out on that extra hours of sleep in your comfy bed. It can also be opting to do freelancing than a 9:00- 5:00 job or vice versa. Opportunity cost penetrates every dimension of life and various kinds of life affairs- that you choose consciously or unconsciously.

Opportunity cost by definition means, any concept that is economic in nature and is used to increase/maximize the worth- with better decision making. This term is usually applied in finance, accounting and economics which simply arose from sacrifice of surrendered opportunities which may have given support in gaining other possible opportunities.

Opportunity cost(s) are thus not just relating to finances and economics. It is basically how life operates, when many alternatives are thrown to life- because of which, life sacrifices some things- to get some other things. Though, in some instances- the choosing of best alternative might be leading a person towards fruitful and more purposeful journey and sometimes the sacrificed alternatives could have been the best alternative- that simply got missed.

There is also a Law on increment of opportunity cost. This law suggests that- if businesses soar the goods production of (Goods A), then the opportunity cost to produce/manufacture an added/extra good (Good A or Good B) will fly up. Economists and Finance people need to give a substantial thought on this as well.

What Can Happen Because Of Opportunity Cost?

Prospective changes take place– The changes can be pleasant or not so pleasant, depending on what sort of substitute you choose or do not choose.

Every time we need to forgo– If your immediate best alternative to traveling is spending time with your family- then the opportunity cost here can be forgoing of pleasure and satisfaction to have been able to spend time with your loved ones and on top of this,- the opportunity cost of traveling becomes- the hefty amount of money that would be spend during traveling. Hence, it so happens that every time there arrives the need of forgoing some or the other things- if we start taking opportunity cost into consideration.

Decision making gets affected– Sometimes with choosing a certain alternative- opportunity cost may be causing benefit to you- and sometimes you may lose out on the opportunity that might have led you to a better path. Hence, your decision making is affected continuously.

Additional development– Opportunity cost can flare up additional development of problems or explode an array of possibilities and solutions.

Determination of present and future– Opportunity cost that occurs prior- allows you to ponder upon future possibilities helping you to choose best alternatives if analysed properly.

Fundamental to economists– Resources are scarce in comparison to needs; one way use of resources may create prevention in use of resources the other way. Opportunity cost can be evaluated in terms of effectiveness of costs and cost utility studies.

Cost utility studies – If two or many involutions are made comparisons- then- cost utility study can make the opportunity cost of alternative sources being utilized- explicit/crystal clear.

Cost effectiveness ratio– When different involutions take place- the outcome of which is represented as Rs/outcome allows, cost occurrence of different interventions to be compared.

Inaccurate conclusions– There might be difficulties of applying opportunity cost concept- if opportunity cost calculation is not performed with proper analysis. This can also cause the numerical assumptions to create inaccurate conclusions.

Utilization of data– Utilization of comprehensive and disaggregated data and use of data science is necessary for opportunity cost finding. Hence, accounting practices usually try to avoid calculating opportunity cost because of the amount of data that it would require. The point here is that, in many economic evaluations- the data of accountancy practices relating to costs are taken into consideration. So can the opportunity cost derived on the basis of accountancy data be considered as fully reliable?

Social value and no seen market – Usually social works are kept as personal works and people don’t feel comfortable to show off in public. There might not be much reflection on who has performed social work, on what level and how this has been performed. There might be a lack of data, resources and understanding on the size and capacity of the social work market. In this case, opportunity cost may not be fully accurate- yet it can be assumptions based.

No cash involvement case– Sometimes opportunity costs may occur without being noticed and may not involve cash and resources transactions.

The Economics Of Opportunity Cost

How does economics define opportunity cost? The choosing of one expenditure atop another- causes many opportunities to pass over. These opportunities forgone are termed as opportunity costs in economics. There are always two or many alternatives! So, the next best valued utilization of substitutes’ and resources’ creating overall value at that time period- is the opportunity cost.

Isn’t opportunity cost actually superfluous and redundant? Though, sometimes- incase of a profession such as lawyers- superfluousness can be a virtue as well. The virtue actually “reminds”- that the cost of utilization of certain resources erupts from missing out on the utilization of the same resources- though it could be utilized.

For example- In the education sector- when the government announces subsidies- then also, some students need to pay a little more than what needs to be paid- due to the incurring of extra cost of resources.

Let us look at a mere example of how a student need to pay her/his dues:

If a student needs to pay 474364.40 NPR annually in college. The subsidy to the college provided by the government (assumed) is 948728.80 NPR . Here, it may seem that the cost is 1423093.20 NPR and students’ payment to college is even lower than half. Though, is it actually what it looks like? Remember- looks can be swindling!

So, what is the real cost? The real cost is 1423093.20 NPR plus ( + ) the chances (income, salary) that students let go, to attend college rather than going to work. This kind of opportunity cost is usually not given thought of. Hence, even the economists while performing economic theories and calculations for education sector awareness need to include opportunity cost calculation to derive the level of achievement in comparison to utilization of available resources and what could have been used (probable resources+ conditions).

Here, if the student could have earned 2371822.00 NPR yearly, then the real cost of college could become 1423093.20 NPR plus 2371822.00 NPR, for a total of 3794915.2 NPR. Out of this 3794915.2 NPR total, as tuition= 2846186.40 NPR and 2371822.00 NPR = left/foregone income or earnings. So, although the government would provide a massive subsidy, the student would be paying 75% of the overall cost.

The opportunity cost concept allows economists and finance and accountancy related people to inspect, examine and perform surveys of relative monetary value of goods as well as services.

Opportunity Cost In Terms Of Finance

In simple terms, opportunity cost is also calculated as OP (Opportunity Cost)= FO (Return on best foregone option)- CO (return on best chosen option).

Some other formula as per coursera is, Opportunity Cost = Return On Most Profitable Investment Choice (-) Return On Investment Chosen to Pursue.

Basically, In economics, accounting and finance terms- it is very important to find out

Explicit Costs
Implicit Costs
Income/earnings
Economic profit
Accounting profit

Here, Explicit Costs and Implicit costs are two types of Opportunity Costs.

Opportunity cost that incur = Explicit Cost in addition with Implicit Cost ie, OP= EC+IC

Economic profit that takes place = Income/Earnings subtracting the Opportunity Cost i.e, EP=I-OP

Accounting profit that is generated= Income subtracting the Explicit Costs i.e, AP=I-EC

Here, Explicit costs= Those costs that are direct costs. For eg, costs provoked due to operations of businesses such as operating costs are explicit costs. It can be a cash transaction or barter of resources (can be any). These kinds of costs can be known easily, as they occur during the operating procedure for businesses and are easily recognizable. For example: salary of staff can be termed as explicit costs. It is found in the income statement and balance sheet and speaks for the cash flow of any businesses.

Some of the explicit costs are:

Explicit operations cost + Explicit Maintenance Costs

Wages Costs
Rent costs
Overhead costs
Materials and resources costs

Explicit Land Costs and Infrastructure Costs

Implicit costs= Implicit costs are actually the opportunity cost(s) when resources are utilised although those costs could be utilised for something else or some other purposes. Even with a wide eye open- these sorts of costs cannot be seen well enough. For eg,- these costs may already happen/occur in the works performed- without getting attention. Suppose, there is a partnership agreement happening between a bank and an insurance company for insuring their employees. If, the bank would thus go ahead with the partnership without a quick survey with their employee union- then, there might occur a questionable circumstance(a cold misunderstanding) created by the conversation missing situation which may cause the contract between the insurance company and the bank to become a reason for unhappiness among employees and employee union, as the employees could not see required sense of safety.

Current example of Banking and Financial Institutions’ Employee Union and employees revolting against the Social Security Fund (SSF)’s rule with regard to deposition of employee’s money in SSF shows that Social Security Fund Office- didn’t consider the opportunity cost that SSF would attract by asking- Bank and Financial Institutions to agree to the rules of SSF. Probably, the Social Security Fund couldn’t map out the ability of the Employee Unions of Banking and Financial Institutions. The Supreme Court spoke more on the favourable side of the Bank and Financial Institutions’ employees or employees in general. Whereas, the Bank and Financial Institutions definitely managed to deal with the situation by predicting and analysing the opportunity cost happening condition and swiftly made it in favour for them.

Having said that- the opportunity cost for Bank and Financial Institution can be- supposed yet (undecided/assumed) long term deprivation of added benefit of a more developed Nation- as Social Security falls in the framework of International Labour Organization- making up ILO’s standard. Nepal has been ILO’s member since 1966.

International Labour Organization in its website has mentioned the following:

The Conventions and Recommendations which make up the ILO’s standards framework on social security are unique: “They set out minimum standards of protection to guide the development of benefit schemes and national social security systems, based on good practices from all regions of the world”

Though ILO has also mentioned that – “They are therefore based on the principle that there is no single model for social security, and that it is for each country to develop the required protection. For this purpose, they offer a range of options and flexibility clauses for the progressive achievement of the objective of the universal coverage of the population and of social risks through adequate benefit levels.”

Henceforward, it can be clearly known, that the opportunity cost for Nepal’s Social Security Fund Organization could have been well analysed and predicted earlier to best suit the employees.

Implicit Costs thus may include the following as well:

Labour, Human Resources Costs
Infrastructure Costs
Time Costs

What Is Economics Profit ?

Economics Profit is a profit that is connected with opportunity cost. Which means- Opportunity cost(s) are also aligned with Economics Profit. The reason for calculating economics profit is to support in making good decisions for organizations/businesses which let the businesses to find out- if proper assigning of resources has been done or not and to see if it requires further reshuffling of resources. Henceforth, it touches upon the cost benefit analysis for works of organizations.

What is Accounting Profit?

Accounting Profit is the profit recorded in the following:

Balance Sheets of organizations
Organizations’ Cash Flow Statements
Organizations’ Income statement

It is written down/recorded- having seen usual financial/monetary value. It deals with money in any form.

It is completely measurable and not hidden and provides organizations’ fiscal performances. In Nepal also, there is a process of recording accounting profit by calculating measurable activities and changes- quarterly, bi- annually and annually. {eg, Fiscal year calculation of Nepal is done from Shrawan 1 to Asar End every year (B.S)}

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Is It Necessary To Determine Opportunity Cost?

To gain results that are not just quantitative and measurable and to understand the hidden and concealed costs- determining opportunity cost can definitely help in long term sustainability of businesses/ organizations/companies, if all the possibilities are analyzed smoothly.

Cost benefit as well as economic benefit can be gotten through opportunity cost analysis. It is also very important in making savings and Investment decisions. It helps to ascertain potentiality of profits or chances of losses.
Prioritising becomes easy with opportunity cost analysis.
It helps to identify relative prices of options that you have.
It creates an awareness about the opportunities that have been missed and/or automatically contributes to the thought process of upcoming potential/favourable opportunities.

Thus, most often, we should pursue those things that we value the most, that which is purposeful and should have full awareness about what we are pursuing- just considering our any pursue- as our pursuit for happiness; because – there might be a lot of losses of opportunities- on the way, but our decisions and our sacrifices should always give out the best value. The opportunity cost associated with our doings should create potential benefits rather than detriment in a larger sense.

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