Scarcity refers to the basic economic problem, there is a finite amount of resources and a limitless amount of needs and wants. This scenario therefore requires people to make decisions about how best to allocate those resources efficiently in order to achieve as many needs and wants as possible.
In a hypothetical world in which every resource in which there was an infinite amount of resources there would be no need to make decisions about how to allocate resources, and no tradeoffs. However, in the real world, everything costs something because resources are scarce.
Money and time are typical scarce resources we think of. If you're unemployed you have lots of free time to do hobbies but very little money. Often we exchange some of our time at a job for money in which we can enhance the quality of our free time.
Opportunity cost represents the benefits you miss out on when choosing one alternative over another.
When assessing what is the best decision to make look the potential profitability or return of your decision. Let's think about this in our daily lives and consider this formula:
Opportunity cost = return of most lucrative option not chosen - return of chosen option
When making larger decisions like buying a home or a car it is more natural to think about the pro and cons and to weigh the costs of your decision. If I buy that car now I can't go on that Europe vacation I was planning. However, when the transactions get smaller it is more likely that we overlook the opportunity cost and simply make the decision. Buying one $5.00 coffee a day doesn't seem like a decision we should scrutinize, but there is always a cost. Perhaps the opportunity cost is going for a nice dinner on Friday night with the $25 you saved throughout the week, perhaps the opportunity cost over a full year (365 days x $5 = $1,825) is going on a week vacation to Mexico or investing that money into a savings account that collects interest. This isn't to discourage you from enjoying your daily coffee, but rather to illustrate the value of weighing opportunity costs of your decisions. These also manifest in non-monetary scenario's. Spending 2 hours of time with that person you like over doing 2 hours of homework has it's own opportunity costs as well with either decision you make. Let's look at another big life decision. What is the opportunity cost of a 4 year degree and working right out of high school. Ultimately there are many factors involved but we'll keep it simple using this hypothetical:
A) Working now at the age of 18 at a job that pays $35,000 a year till retirement at 65 years of age.
B) Going to school for 4 years starting at 18, cost of school is $18,000 a year and the salary of job after the degree is $40,000.
What are the opportunity costs?
A) The net wages earned in this scenario is 47 years of work at $35,000 = $1,645,000 by retirement.
B) The net wages earned in this scenario is 43 years of work (because of years in school) at $40,000, minus the cost of the education $72,000 = $1,648,000 by retirement.
In this hypothetical scenario the opportunity cost is very comparable despite the higher salary of situation B.
What is the Difference Between a Sunk Cost and an Opportunity Cost?
The difference between a sunk cost and an opportunity cost is the difference between the cost already incurred versus the future potential costs yet to be incurred.
Consider this example, if you purchase a non-refundable ticket to a Canucks games and then got ill on the night of the game, the decision to attend the game while sick or stay at home and recover would not include the ticket price as that cost is sunk and cannot be altered. Rather the opportunity cost decision would lie between whether you would enjoy going to the game while sick or staying at home relaxing and recovering from your illness.