If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book…. Sunk costs should be irrelevant for future decision making, while opportunity costs are crucial because they reflect missed opportunities. That’s not to say that your past decisions have no effect on your future decisions, of course. You’ll still have to pay off your student loans income statement whether or not you continue in your chosen field or decide to go back to school for more education.

Core Concepts

Opportunity cost is certainly a useful concept to our everyday lives. But economists also use this tool to determine the possible benefits of trade, which we’ll explain in the video. This is one of the most fundamental concepts in economics and understanding opportunity cost is crucial to decision-making. If the government offers an income tax cut, the opportunity cost is that government revenue cannot be used to finance some aspect of government spending. Opportunity cost represents the benefits you forgo when choosing one alternative over another. It’s not just about money—it’s about the potential value or benefit of the option you didn’t take.

Further Reading

Although this result might seem impressive, it is less so when you consider the investor’s opportunity cost. If, for example, they had instead invested half of their money opportunity cost means that something needs to be in the stock market and received an average blended return of 5% a year, their portfolio would have been worth more than $1 million. Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost. The concept of marginal cost in economics is the incremental cost of each new product produced for the entire product line.

• Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years.
• Yet “crowding out” is inevitable, for the same million cannot be spent on two alternative projects, each of which costs a million.
• If we want more of something, we have to give up some of something else.
• On the other hand, Company B had a return of 10% in the same year.

Societal Decisions

Economists use the term opportunity cost to indicate what must be given up to obtain something that’s desired. A fundamental principle of economics is that every choice has Accounting For Architects an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss. If you spend your income on video games, you cannot spend it on movies.

You are also encouraged to consult your legal, tax, or investment professional regarding your specific situation. Registration does not imply a certain level of skill or training. The value of your investment will fluctuate, and you may gain or lose money.

Accounting profit is the net income calculation often stipulated by the generally accepted accounting principles (GAAP) used by most companies in the U.S. Under those rules, only explicit, real costs are subtracted from total revenue. Money that a company uses to make payments on its bonds or other debt, for example, cannot be invested for other purposes. So the company must decide if an expansion or other growth opportunity made possible by borrowing would generate greater profits than it could make through outside investments.