Despite popular belief, economics is the study of choice rather than the study of money. Economists use money as a measurement for what choices individuals, businesses and countries are making.
Understanding economic decision-making tools can help entrepreneurs and businesses to make the best choices when establishing their vision.
The first economic tool entrepreneurs should understand is opportunity cost. Understanding opportunity cost will reveal to entrepreneurs if they are throwing good money after bad.
What is Opportunity Cost?
When people say they are “weighing up their options”, they consider what economists call opportunity cost.
The fundamental basis of economics is that we cannot have everything we want because all resources are limited (time, money, water). Every time we make a choice, we sacrifice the other available options. Economists assume, when we make a choice, we are subconsciously asking ourselves:
- How much do I value this?
- What am I giving up now to have this?
- What am I giving up in the future to have this now?
To put it simply, opportunity cost is the cost of a missed opportunity. Whenever someone chooses to pursue one type of business activity, naturally, they must forgo a different kind of activity. For example, if one chooses to start a business, they cannot spend their time as an employee working for a wage.
In this scenario, an economist would assume that starting a business is seen as a more valuable choice now and in the future than working for a wage.
If a decision has a “high opportunity cost”, meaning that the value of a missed opportunity is higher than the chosen option, economists consider it “inefficient.”
If a decision has a “low opportunity cost”, it means the chosen decision has a higher value than any forgone options; economists would consider it “efficient.”
Considering Opportunity costs when making business decisions
Every business choice has an opportunity cost.
Because opportunity cost is an unseen cost, it is easy to overlook when making decisions. Carefully considering other options can prevent entrepreneurs from spending time, money and other resources on an ultimately less valuable choice.
Understanding opportunity cost helps individuals and businesses carefully consider all viable alternative options and look beyond basic monetary costs. Just because something is the cheapest option or the most valuable in terms of money, doesn’t necessarily make it the best.
For example, when starting a business, the cheapest option may be to delay bringing y employees on board; however, the opportunity cost here is your time, energy and effort. To assess this decision, you would have to weigh up the cost and benefits in both the long and short term.
Despite being the cheapest option, it might be more efficient to explore employment options if your time and energy are better used elsewhere.
To consider opportunity cost, you should keep in mind:
- In making an informed economic decision, the value of all possible opportunities needs to be based on all benefits and the costs associated.
- Monetary and non-monetary benefits should be considered.
- To assess all options using the same criteria to obtain a proper understanding of their value.
Economic profits and costs
When economists consider cost, they consider more than monetary cost, called “explicit cost”. They also assess the “implicit costs” of a decision. The implicit cost is equal to the opportunity cost.
A business may be achieving an accounting profit, meaning it is making more money than it is losing, but be making no economic profit because resources may be better used elsewhere.
The equation for determining economic profit is Economic profit = revenues – explicit costs – opportunity costs.
For example, If a company generates $20 selling one dress that costs $10 to produce, then its total profit is $10. However, if they could have made shorts with revenue of $20 and costs of $5, there could be an opportunity cost of $15.
$20 – $10 – $15 = -$5
This company is making no economic profit because the implicit costs + explicit costs are higher than the benefits. The company could have earned $5 more by making shorts rather than dresses. Although the company makes an accounting profit, one option is a more valuable choice.
By considering the value of the next best choice, a business can gauge if it is putting its money in the right direction. When establishing a company, opportunity analysis can be used to develop a deeper understanding of business decisions.
Read more: Let’s Talk: Making the hard business choices – admitting & cracking down on what doesn’t work
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