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5 4: Calculating Opportunity Cost

how to calculate the opportunity cost from a graph

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 in the stock market and received an average blended return of 5% a year, their portfolio would have been worth more than $1 million. Their opportunity cost in this case would be over $500,000. Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while the company estimates that the equipment update would generate an 8% return over the same period.

What Is an Example of Opportunity Cost in Investing?

There’s no way of knowing exactly how a different course of action will play out financially over time. Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.” self employment taxes In economics, risk describes the possibility that an investment’s actual and projected returns will be different and that the investor may lose some or all of their capital. Opportunity cost reflects the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment.

Formula for Calculating Opportunity Cost

We will keep the price of bus tickets at 50 cents.Figure 3 (Interactive Graph). Your alternative is to keep using your current vehicle for the next two years, and invest money with a 3 % rate of return. There is a 22 % tax on capital gains, and the inflation rate is 1.5 %. Your interest is compounded monthly – that means your earned interest will be added to your account each month, and next month your interest will be calculated on that new, larger amount. Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years. Assuming an average annual return of 2.5%, their portfolio at the end of that time would be worth nearly $500,000.

  1. As with many opportunity cost decisions, there is no right or wrong answer here, but it can be a helpful exercise to think it through and decide what you most want.
  2. Now we have an equation that helps us calculate the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week.
  3. Keep reading to find more about the assumptions this tool uses, how to calculate opportunity cost, and the opportunity cost definition.
  4. We will keep the price of bus tickets at 50 cents.Figure 3 (Interactive Graph).

Shifters of the Production Possibilities Curve (PPC)

If he buys one less burger, he can buy four more bus tickets. The slope of a budget constraint always shows the opportunity cost of the good that is on the horizontal https://www.kelleysbookkeeping.com/ axis. If Charlie has to give up lots of burgers to buy just one bus ticket, then the slope will be steeper, because the opportunity cost is greater.

how to calculate the opportunity cost from a graph

how to calculate the opportunity cost from a graph

Individuals also face decisions involving opportunity costs, even if the stakes are often smaller. Alternatively, if the business purchases a new machine, it will be able to increase its production. While opportunity costs can’t be predicted https://www.kelleysbookkeeping.com/what-is-periodic-and-interim-reporting/ with total certainty, taking them into consideration can lead to better decision making. Keep reading to find more about the assumptions this tool uses, how to calculate opportunity cost, and the opportunity cost definition.

Remember in the last module when we discussed graphing, we noted that when when X and Y have a negative, or inverse, relationship, X and Y move in opposite directions—that is, as one rises, the other falls. This means that the only way to get more of one good is to give up some of the other. You can see this on the graph of Charlie’s budget constraint, Figure 1, below.

Under those rules, only explicit, real costs are subtracted from total revenue. As with many opportunity cost decisions, there is no right or wrong answer here, but it can be a helpful exercise to think it through and decide what you most want. Suppose, for example, that you’ve just received an unexpected $1,000 bonus at work. You could simply spend it now, such as on a spur-of-the-moment vacation, or invest it for a future trip.

This theoretical calculation can then be used to compare the actual profit of the company to what its profit might have been had it made different decisions. 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.

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