Importance and Risks
Opportunity cost calculation is essential to individuals, corporations and governments, where there are decisions to be made regarding limited resources like time, money and effort. Choosing one of the scarce resources always leads to a trade-off in gains.
It is important to account for risks associated with the different available options. Often the rewards that different options offer come with a certain risk.
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Opportunity cost in non-financial situations is more difficult to quantify. The loss or gain with choosing an option while foregoing another can be subjective and not readily comparable.
Example: While deciding on which job offer to take, we may consider job satisfaction, brand name, commute time, long-term growth, and the salary offered. While finalizing, we have to forego the other best offer. While deciding on a career, we have to consider options like prestige, impact and the work sector.
It is the estimated value of the best alternative or the best option that one misses out as a consequence of picking one particular option.
Example: Spending a limited resource, like Money, on healthcare, comes with the 'opportunity cost' of being unable to spend that amount on education.
Many people and organizations fail to take into account the various opportunity costs.
The way to calculate the opportunity cost is to subtract the value of the option from the value of the alternative that is foregone.
Opportunity Cost = Return on the best foregone alternative - Return on the chosen option.
Certain external constraints make us overestimate the opportunity cost, as we start to imagine all the foregone options as a missed opportunity and start to see the situation irrationally. This can cause a negative emotional and psychological reaction, like regret.
The opportunity cost in these cases should not be viewed as the sum of all your skipped alternatives, but only the value of the best one which is foregone.
If you want to become more aware of opportunity costs in your career, prioritize the important work.
Make a list of your top 5 priorities, keep it in a visible place, and live according to those priorities.
Options are conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called a "premium" by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.
A decision matrix is a table that helps you to visualize the best option between your different alternatives.
It works by getting you to list your options as rows on a table, and the factors you need consider as columns. You then score each option/factor combination, weight this score by the relative importance of the factor, and add these scores up to give an overall score for each option.
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