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Economics Definition: Opportunity Cost

Opportunity Cost is one of the most fundamental concepts in economics. Let's look at its definition as provided by Dictionary.com.

Opportunity Cost: noun
The best alternative that is forgone because a particular course of action is pursued. An example is the interest income that is given up when large balances are kept in a checking account. Likewise, purchasing a home means that less money is available for another investment.

So what does this really mean? Well, in every decision you make, there are pros and cons. The best decision is to pursue the choice that has the best advantage, where the greatest difference lies between the pros outweighing the cons.

Here is a very simplistic example, but it illustrates the point. There are two banks that offer savings accounts that you are considering. Bank A offers a $50 bonus to sign up for an account, with an interest rate of 3%. Bank B offers a savings account with an interest rate of 5% without any bonus. Which is better? As always it depends on how you will use the savings account. Let's say you are going to save $10 per month in the savings account. On day one, your balance with Bank A will be higher. Eventually, there is a point where you balance will be greater with Bank B. This is because of a higher interest rate and compounded interest. If you are saving for short-term, and you will not exceed that point where the balance with Bank B would be greater, then Bank A is the choice. If you will be saving long-term, then Bank B is the choice. However, if you choos Bank B, you miss out on the opportunity to receive the $50 bonus. If you choose Bank A, you miss out on the opportunity to have a higher interest rate.

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