Opportunity cost (also referred to as Alternative cost) is defined by New Oxford American Dictionary as "the loss of potential gain from other alternatives when one alternative is chosen". [1]
As a representation of the relationship between scarcity and choice, [2] the objective of opportunity cost is to ensure efficient use of scarce resources. [3] It incorporates all associated costs of a decision, both explicit and implicit. [4] Opportunity cost also includes the utility or economic benefit an individual lost, it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income. [3]
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By application As a representation of the relationship between scarcity and choice, [2] the objective of opportunity cost is to ensure efficient use of scarce resources. [3] It incorporates all associated costs of a decision, both explicit and implicit. [4] Opportunity cost also includes the utility or economic benefit an individual lost, it is indeed more than the monetary payment or actions taken. As an example, to go for a walk may not have any financial costs imbedded to it. Yet, the opportunity forgone is the time spent walking which could have been used instead for other purposes such as earning an income. [3] Regardless of the time of occurrence of an activity, if scarcity was non-existent then all demands of a person are satiated. It’s only through scarcity that choice becomes essential which results in ultimately making a selection and/or decision.[2] Sacrifice is a given measurement in opportunity cost of which the decision maker forgoes the opportunity of the next best alternative.[5] In other words, to disregard the equivalent utility of the best alternative choice to gain the utility of the best perceived option.[6] If there were decisions to be made that require no sacrifice then these would be cost free decisions with zero opportunity cost.[7] Types of Opportunity CostsExplicit CostsExplicit costs are the direct cost of an action, executed either through a cash transaction or a physical transfer of resources.[4] In other words, explicit opportunity costs are the out-of-pocket costs of a firm. [8] With this said, these particular costs can easily be identified under the expenses of a firm's income statement to represent all the cash outflows of a firm. [9] Examples are as follows: [8][10]
Scenarios are as follows: [9]
Implicit CostsImplicit costs (also referred to as Implied, Imputed or Notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes. These costs are often hidden to the naked eye and aren’t made known.[10] Unlike explicit costs, implicit opportunity costs are normally corresponding to intangibles. Hence, they cannot be clearly identified, defined or reported. [9] In terms of factors of production, implicit opportunity costs allow for depreciation of goods, materials and equipment that ensure the operations of a company. [11] Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes: [8][11]
Scenarios are as follows: [9]
Excluded from Opportunity CostSunk CostsSunk costs (also referred to as Historical costs) are costs that have been previously sustained and cannot be recovered. Since sunk costs are costs that have been incurred, they remain unchanged by both present and future action. [12] Decision makers who recognise the insignificance of sunk costs then understand that the "consequences of choices cannot influence choice itself".[2]
A company used $5,000 for marketing and advertising on its music streaming service to increase exposure to target market and potential consumers. In the end, the campaign proved unsuccessful. The sunk cost for the company equates to the $5,000 that was spent on the market and advertising means. This expense is to be ignored by the company in its future decisions, and highlights that no additional investment should be made.
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