Question

How do you calculate opportunity cost

Answer 1

Opportunity cost is the cost of the alternative which could have been chosen. In case of a building, the money earned by renting it to someone else rather than use it yourself is an example. The opportunity cost is the resulting value when we take accounting profit and remove opportunity cost from it. To explain the building example, assume revenue from business is $10,000 and the cost of business is $8,000. Assuming $500 goes in taxes, we are left with $1,500 in accounting profit. If we could have rented the building for $2,000 then we are left with economic profit of $1,500 - $2,000 which is -$500 which tells us we should have rented the building out rather than run the business. Always aim for positive economic profit. In the same example above, if the rent is anything less than $1,500 we should have run the business and at exactly $1,500 rent we are indifferent to either choice.