What is Opportunity Cost?

opportunity costs

There are some economic terms most of us know and understand, such as supply and demand. And there are other terms we will probably never even run across, like implicit logrolling and a Kondratieff cycle.

In between, though, are all the terms you need to know to help with everyday financial decision making. To mark Financial Literacy Month, throughout April we'll be unpacking key economic concepts -- the ones that affect your everyday finances and investments -- to help you make the smartest choice with every dollar decision you face.

Today's term: opportunity cost.

Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.

Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)

Opportunity cost can help you think rationally about your personal finance and investing decisions, too. Imagine that you're thinking of buying a wide-screen TV for $1,000. It costs a grand, true enough. But there are opportunity costs as well. If you invested that $1,000 in the stock market, for example, and over the next 20 years it averaged a 10 percent growth rate, you'd end up with a bit more than $6,700. So that TV that costs $1,000 today will mean that you're giving up an alternative of $6,700 in 20 years.

The concept of opportunity costs applies to making investing choices, too. There are thousands of stocks in the market, and thousands of bonds and mutual funds. It's easy to become captivated by a certain stock or fund, but is it the best investment choice for your needs? Spend some time thinking about its opportunity cost -- the other stocks and funds you're passing up that might actually be more attractive.

More money terms:
Sunk costs
Cash flow
Net worth

See all money terms to know