Alternative cost, is usually used as a term to explain the cost for a company to choose an alternative over another available alternative. In other words, the opportunity cost is the income that you lose when you do not choose that particular option. The opportunity cost is thus a fictitious cost because it is only a calculation for potential income in the future. The term is usually used when talking about different courses of action for companies, but also in everyday life for private individuals.
Example of alternative cost
Imagine that a company is faced with a choice between two options for action:
- Invest a large sum of money in a project
- Invest the money in a bond that provides a fixed interest rate
If the company chooses to take action alternative 1, to invest the money in the project, the alternative cost will be the interest rate that it would have received if it had chosen action alternative 2.
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When do you use alternative cost calculations?
As I said, you usually use the concept of alternative cost when you are faced with several different action alternatives. Making an alternative cost calculation can simplify the decision for a company that, for example, is faced with several different alternatives for how they should spend their money.
As I said, the concept can also be used in other contexts for both private individuals and companies. If you have a sum of money that you have not decided on what to do with, you can do a simple option cost calculation and compare the different options. Maybe you have the option of depositing them in the bank for x% in interest or investing them in your friend’s project with x% in potential return for example. You can also exemplify the concept in the time lost when you need to work to get paid. The alternative cost for the salary is then the lost time that you could have invested in spending time with your friends, doing other work or some leisure activity, for example.
Known alternative cost example
The concept of alternative costs may seem simple at first glance, but it can also be cumbersome when you mix in several alternatives. A well-known example from the year 2005 that has been included in an economics book is what, in a slightly rewritten form, is explained below. In the study on which the example is based, 200 doctoral students in economics were allowed to answer the question in the example and only 21.6% of the respondents managed to answer correctly. Now let’s see if you can guess right!
- Erik has won a free ticket to an Eric Clapton concert that he cannot sell
- However, Bob Dylan plays the same night as the Clapton concert
- If Erik had not been faced with two different alternatives, the Dylan concert would have been the activity he would have chosen to do
- Tickets for the Dylan concert cost $ 40 but Erik would be willing to pay $ 50 at any time to see Dylan
The question to this dilemma is: What is Erik’s opportunity cost to see Eric Clapton?
- $ 0
- $ 10
- $ 40
- $ 50
The correct answer is option 2. Erik’s benefit from the Bob Dylan concert is $ 10 because he thinks it’s worth $ 50 but only needs to pay $ 40. Erik gives up this benefit by attending the Eric Clapton concert. The choice of whether Erik should go and see Eric Clapton or Bob Dylan thus depends on what benefit he thinks Eric Clapton provides. If the benefit of Clapton is more than $ 10, he should choose that concert, otherwise he should choose Dylan.