Opportunity Cost vs. Monetary Cost
Most people think of costs in monetary figures. Business owners, for example, think of labor, materials and other costs involved in producing their products and services. For economists, cost has another dimension, one that includes not just actual expenditures but forgone opportunities. Economists call these costs opportunity costs, and they form a central element of economic thought.
Producing goods and services requires actual expenditures. Companies must pay workers, purchase production machinery and materials, ensure distribution of products and market them to consumers. These are examples of monetary costs, or the actual expenditures involved in production. Opportunity costs refer to whatever must be forgone to obtain an item or produce a good. For example, a company that allocates resources to produce CD players cannot use those resources to make MP3 devices. For a person who devotes more time to recreation and family, the opportunity cost is income that could be earned from working longer hours.
Economics is all about how individuals, firms and societies allocate scarce resources. Because resources are not unlimited, societies must prioritize their needs and wants. Allocating resources, such as time and money, to one activity means those resources are not available for another activity. This makes opportunity cost an important concept in economic thought. Harvard economist Gregory Mankiw summarized opportunity costs as one of his central principles of economics when he wrote that people face tradeoffs in life and that the cost of something is what people must forgo in order to acquire it.
Applying opportunity costs means that the actual cost of something may be greater than the monetary figures involved. A monetary gain can even be a loss when opportunity costs enter the equation. For example, a person who buys a $150,000 house and sells it 10 years later for $200,000 realizes a monetary gain of $50,000. However, spending the $150,000 on a house means that money could not be invested in a mutual fund that yielded greater monetary returns over the same 10-year period. The opportunity cost of this transaction, then, is the forgone income a person could have realized from investing in that mutual fund.
Some economists distinguish tangible monetary costs from less tangible opportunity costs by referring to explicit and implicit costs. Explicit costs require an outlay of money, according to Mankiw, while implicit costs refer to the forgone opportunities that stem from allocating resources to a particular purpose. For a skilled computer programmer who decides to go back to school for another degree, the opportunity cost is the forgone income earned by those programming skills.