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Opportunity cost explained

What is opportunity cost? There’s opportunity cost of time, and opportunity cost of assets. Let’s explain opportunity cost using several examples. ⏱️TIMESTAMPS⏱️ 00:00 Introduction to opportunity costs 00:40 Opportunity cost example 01:05 Opportunity cost work vs study 02:10 Opportunity cost of assets 03:09 Opportunity cost in economics 03:35 Production Possibility Frontier 07:41 Opportunity cost definition Opportunity cost is something that parents bug their teenage children with. Here’s Tim. He is planning to spend his whole day playing Fortnite, minding his own business. His mom is not excited about his plan: “Get off that couch, get a haircut, and make yourself useful… get a job!”. A job opportunity is right around the corner: the local fast food restaurant is looking for someone to work in the kitchen. So Tim basically has to make up his mind between two alternatives: playing a game that doesn’t cost him anything but makes him no money either, and flipping burgers for $9 per hour. This is where opportunity cost comes in. If Tim decides to play his computer game, then he walks away from $9 per hour. Tim gives up the fun of playing his game, and goes to work instead. But wait! Maybe there is an even better alternative. Instead of working at a fast food restaurant, he could be studying. This is a choice between making money now and making money later. If he studies hard and graduates, he could be making $27 per hour after graduation. Here’s the opportunity cost: if he chooses flipping burgers instead of studying, then he walks away from an additional $18 per hour that he could be making in the future. Tim quits his job at the fast food restaurant, walking away from making $9 per hour now, and goes to study instead, which puts him on the road to $27 per hour in the future. A good follow-up question to ask is: what is the earnings potential from the field of study that you choose? In case Tim chooses cultural anthropology for example, he might not be very employable. Could be that he ends up back at the fast food restaurant making $9 per hour. Opportunity cost does not just apply to time, but opportunity cost can also apply to assets. Here’s Tim’s big brother Bob. He’s got it together! Bob owns a small retail building. He could use the building to set himself up as a barber. He could also rent out the building to Al, who wants to start a shoe shop. What should he do? Bob has to make up his mind between two alternatives: using the building himself which doesn’t cost him anything and gives him the opportunity to earn an income of $30,000 per year as a barber, or renting out the building to Al for $40,000 per year. Here’s the #opportunitycost: if Bob decides to use the building himself, he walks away from $10,000. You could say that, from the perspective of opportunity cost, it is costing him money to be a barber in his own building. Opportunity cost is something that #economics professors bug their students with, mostly in the form of hypothetical examples (starting with the words “Let’s assume…”) that need an opportunity cost calculation. Most of these opportunity cost problems are plain busywork, as they are full of far-fetched assumptions, and very few people would ever think like this in real life. Here’s one such opportunity cost example. Let’s assume you are running a YouTube channel. In any given workweek, you have two and only two ways to grow the channel: making new videos, and optimizing existing videos (thumbnails, titles, keywords, that sort of stuff). You can either make 8 new videos, or optimize 80 existing videos, or a combination of both activities. This curve right here is called the Production Possibility Frontier: a curve illustrating the varying combinations of two activities that can be undertaken when both depend on the same finite resources (in this case: time). Let’s collect some data points. We need to figure out how many existing videos can be optimized when making 1 new video, 2 new videos, 3 new videos, etc. This results in a table with 9 combinations. Opportunity cost is simply the trade-off between the two activities. What is the definition of opportunity cost? The loss of other alternatives when one alternative is chosen. Or even more specific and practical: the value a person could have received but gave up in pursuit of another option. Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!