Every choice you make in life has visible and hidden costs. Buying a slice of pizza costs you $3, but you are also giving up the possibility to eat something else and you can't spend that $3 again. Each choice made means another alternative has been forgone.
A trade-off is isolating what that forgone alternative is, and opportunity cost involves calculating the cost of the trade-off. Trade-off and opportunity cost are therefore linked, with the former helping to calculate the latter.
What's a Trade-Off?
A trade-off is an exchange of one thing for another, or accepting less of one thing for more of another. For example, if you have the choice of seeing your parents, seeing your friends or staying in tonight, you are facing a trade-off. In order to see what your trade-off is, though, you must pick your top two choices.
If you decide you will see your friends, but your next choice would have been to see your parents, then seeing your parents is the trade-off for seeing friends. The trade-off can change depending on the choice you make and what you view as the next best alternative.
Calculating a Trade-Off
There is no specific calculation for a trade-off, so determining the trade-off in any situation is not always easy. When deciding between two or more courses of action, ranking the alternatives from top to bottom can make you feel more confident that you are picking the right one. If you make a choice but cannot accept what you will have to give up as part of the trade-off, consider revising your choice.
What's an Opportunity Cost?
After determining your trade-off, a cost can be assigned to what you have given up. Opportunity cost is the value of the alternative you gave up, plus what your choice costs you. If you choose to see your friends, and not see your parents, you not only give up seeing your parents – a cost – but you may also spend money while out with your friends. To determine the opportunity cost of a decision, you add up the costs of passing up the next best alternative.
Calculating Opportunity Cost
Opportunity cost calculations require looking at decisions in a way you may not have considered before. If you spend $30 while out with friends, but would have spent nothing seeing your parents, $30 must be added to opportunity cost. Your choice to see your friends therefore cost you the opportunity of seeing your parents, plus $30, which you could have spent on something else in the future. Calculating your opportunity costs can aid in decision making, as you will be able to see the effects of your choices.
Cory Mitchell has been a writer since 2007. His articles have been published by "Stock and Commodities" magazine and Forbes Digital. He is a Chartered Market Technician and a member of the Market Technicians Association and the Canadian Society of Technical Analysts. Mitchell holds a Bachelor of Management in finance from the University of Lethbridge.