How Economists Evaluate Choices (ECON-BASICS)
4 Minute Read
Definition
The opportunity cost of an item is the value of the next best alternative that you give up to obtain that item. (Gans, 2021)
Opportunity cost is a forward looking examination.
People face trade offs
Everyone faces trade offs - whether you think about it or not, there is always a cost that you forgo, may that be different courses of action, investments, or uses of our time and resources. Choosing one option means giving up the potential benefits or opportunities of another. This is because resources are scarce. This is where opportunity cost comes into play.
The opportunity cost of a choice is the value of the best alternative forgone.
Opportunity Cost Formula
There are two types of costs:
Explicit = out of pocket expense.
Implicit = are a type of opportunity cost, like time, effort. (it is hard to quantify. “They are technically not incurred and cannot be measured accurately for accounting purposes.”).
The economic cost of a decision is what you pay out of pocket plus the value of the best alternative forgone.
Opportunity cost of choosing X = net benefit of the next best alternative forgone.
Explicit vs Implicit costs
Net benefit
Net benefit = expected benefit - (explicit + implicit)
The opportunity cost of the chosen option is the net benefit of the next best alternative.
For each option, find net benefit: write down expected return, then add explicit + implicit costs. Now compute net benefit: expected return - costs
Step 1:
Step 2:
Also find the next best alternative and calculate net benefit.
Pick the option with the highest net benefit.
Then, calculate the opportunity cost of X = net benefit of next best alternative
Optional: Even if you can’t quantify the implicit cost, if you can’t work out the value.
Step 3:
Examples
An investor has two options:
1. Option A is expected to return 25
explicit + implicit = 5
So net benefit = 25-5 = 20.
2. Option B is expected to return 30
explicit + implicit = 7
Net benefit = 30 - 7 = 23
Choose the option with the highest net benefit.
Option A net benefit: 20
Option B net benefit: 23
Best option: B
The opportunity cost of option B is = net benefit of A (20).
Example 1.
You own a small butchery.
You have two choices for your Sunday:
1. Open the bakery, expected revenue $1000
- explicit: 200 (ingredients, staff)
- implicit: 100 (time, energy from you)
Net benefit: 700
2. Take a one day job offer to work at a cafe and expect $500 (gross)
- explicit: 100 (transport, idk)
- implicit: 100
Net gain: 300
Net benefit of bakery day: $700
Net benefit of cafe day: $300
Best option: Bakery
Opportunity cost of bakery is the net benefit of the next best alternative (300).
Example 2.
Clean environment vs high level of income
In modern society, we must weigh up the costs and benefits between a clean environment and a high level of income.
By choosing a clean environment (health benefits, fewer sick days) you forgo a higher income because a clean environment means higher production costs for companies through taxes used to resolve these market failures. Higher production costs mean firms pay you lower wages, charge you higher prices, or a combination of the two. Or if you choose higher income, you forgo the health benefits and fewer sick days, perhaps increased productivity too. (I’m not giving my opinion on what you should choose!)
Example 3.
A vs B situation vs “one more activity”
Ask yourself:
”If this “perk” disappeared, would the decision change?
If not, it’s not a marginal change.
If yes, this is a marginal change.
So when you’re doing an opportunity cost analysis, and it isn’t an A vs B situation, rather a “shall I add one more of this activity” = think at the margin. Thinking at the margin means considering the additional benefit or cost of a small change in your current situation.
First year Economics student here. Any issues? Please email me at
polonomic.papers@gmail.com
References
Fernando, Jason. “Opportunity Cost: Definition, Calculation Formula, and Examples.” Investopedia, 31 May 2025, www.investopedia.com/terms/o/opportunitycost.asp.
Gans, Joshua, et al. Principles of Microeconomics. South Melbourne, Victoria, Australia, Cengage Learning Australia, 2021.
Hayes, Adam. “Cost-Benefit Analysis: How It’s Used, Pros and Cons.” Investopedia, 25 July 2024, www.investopedia.com/terms/c/cost-benefitanalysis.asp.
Khan Academy. “Explicit and Implicit Costs and Accounting and Economic Profit.” Khan Academy, 2017, www.khanacademy.org/economics-finance-domain/microeconomics/firm-economic-profit/economic-profit-tutorial/a/explicit-and-implicit-costs-and-accounting-and-economic-profit-cnx.
Wikipedia Contributors. “Opportunity Cost.” Wikipedia, Wikimedia Foundation, 18 June 2019, en.wikipedia.org/wiki/Opportunity_cost.