Topic#22
Eric Nault
Jason Gornto
Shane Tullis

Opportunity Cost

Opportunity cost is a cost associated with a decision that includes both the explicit and implicit costs. The unique aspect of opportunity cost is that it also includes costs associated with making an alternate decision. The costs associated with an alternative are called implicit costs. The accounting cost of making a decision is called the explicit cost.

While explicit, or accounting, costs are fairly easy to calculate, implicit costs are not as easy. Measuring the cost of the best foregone alternative can be not as easy as anticipated. By reading this Wiki right now, you are paying an implicit cost of your next best alternative. This can and often will be different for everyone. For you, it may be that the next best alternative instead of reading this is watching television. For someone else, it may be surfing the internet.

IMPLICIT COST
A cost that is represented by lost opportunity in the use of a company's own resources, excluding cash. These are intangible costs that are not easily accounted for. For example, the time and effort that an owner puts into the maintenance of thecompany|company rather than working on expansion.

EXPLICIT COST
A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious outflows from a business that reduce its bottom-line profitability. This contrasts with less-tangible expenses such as goodwill amortization, which are not as clear cut regarding their effects on a business's bottom-line value. Good examples of explicit costs would be items such as wage expense, rent or lease costs, and the cost of materials that go into the production of goods. With these expenses, it is easy to see the source of the cash outflow and the business activities to which the expense is attributed

Examples and Applications
Example 1: An example of an opportunity cost would be the choice of whether to choose leisure for an entire day or to work for an entire day. In this example the explicit cost would be any money that was spent on leisure, tickets to a baseball game for example, and the implicit cost is the money that you could have made while working. These quanitities added together equals the true opportunity cost.
For a "real world" application of this topic let's consider the choice between working for someone else and opening your own business. The investment, cash, and other reciepts are easily calculated by an accountant as the explicit cost of opening a business. To find oppotunity cost you need to caluculate the implicit cost of this decision. The implicit cost of not working for company may include salary, retirement plans, healthcare, bonuses, and stock options. These implicit costs are often times not easily calculated, but often it is better to consider an estimate so that one can calculate opportunity costs of a decision. By going through the rigor of calculating the implicit and explicit costs you will be able to make an informed decision on wether to work for a company or open your own business.

Example 2: You are an engineer. The free market annual salary for someone of your precise level of education and overall training is $50,000. However, you are also skilled as a computer programmer. Your computer programming skills at this time are not as of as much value to the free market. The most that you could make at this time as a computer programmer is $45,000. Please note, this $45,000 is an opportunity cost (an implicit cost in this case) if and only if you can make no more than $45,000 per year in any other endeavor. This ties back to the best opportunty foregone. In your case, the best opportunity foregone to pursue engineering for this year is becoming a computer programmer and making $45,000. This $45,000 is the opportunity cost of you being an engineer for this year.

External Links and References:
1) Managerial Economics and Business Strategy (5th Edition), pg 5-6, Michael R. Baye
2) www.wikipedia.com, Implicit Cost and Opportunity Costs
3) www.answers.com, More on Implicit Costs
4) www.answers.com , More on Explicit Costs
5) www.estu.edu , More on Implicit and Explicit Costs from Dr. Hipple of East Tennessee State University
6) www.amosweb.com , All About Costs, including Explicit Costs and Implicit Costs
7) www.amosweb.com , Detail on Implicit Costs
8) www.amosweb.com , Detail on Explicit Costs
9)http://www.investopedia.com/terms/e/explicitcost.asp
10)http://mbaecon.wikispaces.com/Total+cost+including+implicit+and+explicit+costs, Link to other Wiki Space "Total Cost, Including Implicit and Explicit Costs"
11)Managerial Economics and Business Strategy (5th Edition), pg 14-15, Michael R. Baye




Vocabulary Terms and Phrases to Know Before Leaving This Page:
1) opportunity cost
2) explicit cost
3) implicit cost
4) accounting cost
5) economic cost
6) best foregone alternative



Example Multiple Choice Questions:
Question 1
The opportunity cost of a resource
a. includes both explicit and implicit costs
b. includes explicit costs only
c. includes implicit costs only
d. is equal to the market price of the resource

Answer: a. The opportunty cost of a resource includes both explicit and implicit costs. Explicit costs are opportunity costs that usually involve a monetary payment. Implicit costs usually do not involve a monetary payment - they deal with the foregone satisfaction of the resource. By definition, both explicit and implicit costs are opportunity costs.


Question 2
The term opportunity cost is most often used synonymously with the term...
a. implicit cost
b. explicit cost
c. economic cost
d. sunk cost

Answer: c. Opportunity cost and economic cost are two terms that can be used interchangeably. Implicit and explicit costs are simply compenents of opportunity costs. And a sunk cost is not an opportunity cost at all - it is a cost that has already been paid and should be a factor in no economic decision.


Question 3
The opportunity cost of producing a good relates to the accounting costs in which of the following ways:
a. The opportunity cost of producing a good is usually less than the accounting cost of producing the same good.
b. The opportunity cost of producing a good is usually equal to the accounting cost of producing the same good.
c. The opportunity cost of producing a good is usually greater than the accounting cost of producing the same good.
d. The opportunity cost of producing a good is not related to the accounting cost of producing the same good in any of the above ways.

Answer: c. The opportunity cost of producing a good is usually greater than the accounting cost, because the opportunity cost includes both the dollar value of costs and any implicit costs as well.


Question 4
Harry Bigbucks is considering a run for President of the United States of America. His campaign will last the entire year of 2008. Harry has asked his brother, an accountant, to calculate the costs of his campaign. They have calculated $10 million for television advertisements, $5 million for mailed flyers, $3 million for travelling across the country to speak his message, and $1 million to hire lawyers to help him. In 2007 Harry made $10 million dollars from his job working as a consultant, and his 2008 salary was schedule to increase by 20%. Harry would not have been able to do anything more valuable than working in 2008. Upon making all of the calculations, Harry's brother proclaims, "Harry if you want to run for President, your total economic costs are $19 million." Is Harry's brother correct?
a. Of course it is - why would his brother have an incorrect answer?
b. No - the stated economic costs of $19 million do not include the trip that Harry wants to make to the moon in 2011.
c. No - the stated economic costs of $19 million do not include the settlement of a lawsuit that Harry paid in 2005 for $2.5 million.
d. No - the stated economic costs of $19 million do not include the $12 million that Harry would have made in 2008 as a consultant.

Answer: d. Total economic costs include both the explicit costs of his campaign, which total $19 million, plus the implicit costs of his next best foregone alternative, which was consulting. Harry's brother, the accountant, needs to learn more about economics and add in the $12 million that Harry would have made as a consultant in 2008! The lawsuit that Harry paid off in 2005 are not economic costs of his 2008 campaign. The trip to the moon in 2011 is not relevant to hs 2008 campaign either.