Opportunity Cost

Definition: The potential benefit given up when one alternative is selected over another.

Key Characteristics

Characteristic	Implication
Not recorded in accounting system	Must be explicitly considered in analysis
Equals value of best foregone alternative	Not sum of all alternatives
Can exceed explicit costs	A “free” option may have high opportunity cost

Incomplete Analysis Example

A company owns a parking lot losing $10,000/year. They consider building an office there. Textbook says: “No opportunity cost—using the lot eliminates the loss.”

What’s missing:

Alternative Use	Potential Return
Sell land, invest proceeds	Market returns on capital
Lease to third party	Rental income
Different development	Higher-value use
Keep parking lot	−$10,000/year

Opportunity cost = best of these alternatives, not just current use.

Complete Decision Framework

Include:

• Differential costs (what changes)
• Opportunity costs (what you give up)
• Relevant benefits (what you gain)

Exclude:

• Sunk costs (already spent)
• Costs identical across alternatives

Connection to Economics

Concept	Relationship
Production Possibilities Frontier	Slope = opportunity cost of one good in terms of another
Marginal Rate of Transformation	Opportunity cost at a specific point
Comparative Advantage	Based on relative opportunity costs

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North: Where this comes from

• Scarcity (finite resources force tradeoffs)
• Costs for Decision Making (parent framework)

East: What opposes this?

• Explicit Costs (recorded in accounting system)
• Sunk Cost (already spent, no alternative use)

South: Where this leads

• Capital Budgeting (comparing investment alternatives)
• Make or Buy Decisions (what else could resources do?)
• Capacity Constraint Decisions (which product to prioritize)

West: What’s similar?

• Economic Profit vs Accounting Profit (economic profit includes opportunity cost)
• Implicit Costs (another name for opportunity costs)
• Time Value of Money (opportunity cost of capital)