Opportunity cost is the cost related to the next-best choice available to someone

who has picked among several mutually exclusive choices.[1] It is a key concept in
economics. It has been described as expressing "the basic relationship between
scarcity and choice."[2] The notion of opportunity cost plays a crucial part in
ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are
not restricted to monetary or financial costs: the real cost of output forgone, lost
time, pleasure or any other benefit that provides utility should also be considered
opportunity costs.
Opportunity Cost
Scarcity of resources is one of the more basic concepts of economics. Scarcity
necessitates trade-offs, and trade-offs result in an opportunity cost. While the
cost of a good or service often is thought of in monetary terms, the opportunity
cost of a decision is based on what must be given up (the next best alternative) as
a result of the decision. Any decision that involves a choice between two or more
options has an opportunity cost.
Opportunity cost contrasts to accounting cost in that accounting costs do not
consider forgone opportunities. Consider the case of an MBA student who pays
$30,000 per year in tuition and fees at a private university. For a two-year MBA
program, the cost of tuition and fees would be $60,000. This is the monetary cost
of the education. However, when making the decision to go back to school, one
should consider the opportunity cost, which includes the income that the student
would have earned if the alternative decision of remaining in his or her job had
been made. If the student had been earning $50,000 per year and was expecting a
10% salary increase in one year, $105,000 in salary would be foregone as a result
of the decision to return to school. Adding this amount to the educational expenses
results in a cost of $165,000 for the degree.
Opportunity cost is useful when evaluating the cost and benefit of choices. It often
is expressed in non-monetary terms. For example, if one has time for only one
elective course, taking a course in microeconomics might have the opportunity cost
of a course in management. By expressing the cost of one option in terms of the
foregone benefits of another, the marginal costs and marginal benefits of the
options can be compared.
As another example, if a shipwrecked sailor on a desert island is capable of catching
10 fish or harvesting 5 coconuts in one day, then the opportunity cost of producing
one coconut is two fish (10 fish / 5 coconuts). Note that this simple example
assumes that the production possibility frontier between fish and coconuts is linear.
Relative Price
Opportunity cost is expressed in relative price, that is, the price of one choice
relative to the price of another.

For example, if milk costs $4 per gallon and bread costs $2 per loaf, then the
relative price of milk is 2 loaves of bread. If a consumer goes to the grocery store
with only $4 and buys a gallon of milk with it, then one can say that the opportunity
cost of that gallon of milk was 2 loaves of bread (assuming that bread was the next
best alternative).
In many cases, the relative price provides better insight into the real cost of a good
than does the monetary price.
Applications of Opportunity Cost
The concept of opportunity cost has a wide range of applications including:

Consumer choice
Production possibilities
Cost of capital
Time management
Career choice
Analysis of comparative advantage

What Does Opportunity Cost Mean?

1. The cost of an alternative that must be forgone in order to pursue a certain
action. Put another way, the benefits you could have received by taking an
alternative action.
2. The difference in return between a chosen investment and one that is necessarily
passed up. Say you invest in a stock and it returns a paltry 2% over the year. In
placing your money in the stock, you gave up the opportunity of another
investment - say, a risk-free government bond yielding 6%. In this situation, your
opportunity costs are 4% (6% - 2%).
Investopedia explains Opportunity Cost
1. The opportunity cost of going to college is the money you would have earned if
you worked instead. On the one hand, you lose four years of salary while getting
your degree; on the other hand, you hope to earn more during your career, thanks
to your education, to offset the lost wages.
Here's another example: if a gardener decides to grow carrots, his or her
opportunity cost is the alternative crop that might have been grown instead
(potatoes, tomatoes, pumpkins, etc.).
In both cases, a choice between two options must be made. It would be an easy
decision if you knew the end outcome; however, the risk that you could achieve
greater "benefits" (be they monetary or otherwise) with another option is the
opportunity cost.

The cost of passing up the next best choice when making a decision. For
example, if an asset such as capital is used for one purpose, the opportunity
cost is the value of the next best purpose the asset could have been used for.
Opportunity cost analysis is an important part of a company's decisionmaking processes, but is not treated as an actual cost in any financial
statement.

David Ricardo and Comparative Advantage

In economics, the law of comparative advantage refers to the ability of a party
(an individual, a firm, or a country) to produce a particular good or service at a
lower opportunity cost than another party. It is the ability to produce a product with
the highest relative efficiency given all the other products that could be produced. [1]
[2]
It can be contrasted with absolute advantage which refers to the ability of a party
to produce a particular good using less resources than the other.
Comparative advantage explains how trade can create value for both parties even
when one can produce all goods with fewer resources than the other. The net
benefits of such an outcome are called gains from trade. It is the main concept of
the pure theory of international trade.

In his 1817 book, On the Principles of Political Economy and Taxation, David
Ricardo used the example of Portugal and England's trading of wine and cloth to
illustrate the benefits of specialization and trade. His writing served as the basis for
the principle of comparative advantage, under which total output will be
increased if people and nations engage in those activities for which their advantages
over others are the largest or their disadvantages are the smallest.
Imagine two individuals, A and B, living on a remote island. Two goods are needed
and produced: coconuts and fish. Person A has an absolute advantage in the
production of both goods, able to produce more coconuts than B and more fish than
B. Their production capabilities are summarized in the following table:
Output Alternatives

A -->

Coconuts
|
V

Fish
|
V

10

10

8
3

B -->

Note that the numbers in the above table indicate the maximum amount of one
commodity that could be produced assuming the individual produced none of the
other commodity. For example, if A decided to harvest 10 coconuts, then A would
not be able to catch any fish. Similarly, if B decided to catch 8 fish, then B would
not be able to harvest any coconuts. The values represent the endpoints of each
individual's production possibility frontier. For this discussion, we will assume that
each production possibility frontier is linear as shown below.
Production Possibilities for A and B

If the individuals did not trade, then each would produce both coconuts and fish.
For example, if each spent half of his or her time harvesting coconuts and the other
half catching fish, the output from A would be 5 coconuts and 5 fish, and the output
from B would be 2 coconuts and 4 fish. The total combined output then would be 7
coconuts and 9 fish.
Since both A and B must make trade-offs in their production decisions, they each
have an opportunity cost for each commodity they produce:
Opportunity cost of coconuts

A: 1 fish per coconut. (10 fish per 10 coconuts.)

B: 2 fish per coconut. (8 fish per 4 coconuts.)

Opportunity cost of fish

A: 1 coconut per fish. (10 coconuts per 10 fish.)

B: 0.5 coconut fish. (4 coconuts per 8 fish.)

Since the opportunity cost of coconuts is lower for A than for B, one can say that A
has a comparative advantage in producing coconuts, so A should produce coconuts
to maximize the island's output.
Since the opportunity cost of fish is lower for B than for A, one can say that B has a
comparative advantage in producing fish, so B should produce fish to maximize the
island's output.
If A produces coconuts and B produces fish, then the total combined output would
be 10 coconuts and 8 fish. (versus 7 coconuts and 9 fish without specialization.)
From this example, it might not be immediately obvious that the individuals are
better off - while they have gained 3 coconuts they at the same time have lost one
fish. However, A easily can choose to produce 9 coconuts and one fish, so that the
combined output becomes 9 coconuts and 9 fish. Compared to the case of no
specialization, there is a net gain of 2 coconuts with no loss of fish. By trading with
one another, the two individuals can distribute the goods according to their
preferences, and both are better off as a result of their specialization and trading.
The effect of specialization and trade is an expansion of the production possibilities
for the individuals. Even though A has an absolute advantage over B for both
commodities, they both benefit by specializing and trading.
What Does Comparative Advantage Mean?
A situation in which a country, individual, company or region can produce a good at
a lower opportunity cost than a competitor.
Investopedia explains Comparative Advantage
Let's break this down into a simple example. Suppose that two firms both produce
two main products: ice cream and bicycles. The first firm, the Danish Ice Cream and
Bicycle Co., is located in Denmark, where dairy milk is abundant; the second firm,
the Gobi Ice Cream and Bicycle Co., is smack in the middle of the Gobi Desert.
The Gobi Ice Cream and Bicycle Co. must spend a lot of money to make ice cream,
whereas the Danish Ice Cream and Bicycle Co. spends way less to produce the
same amount. The two firms are dead even in their production costs for bicycles.
Because the Danish Ice Cream and Bicycle Co. has a comparative advantage with
ice cream production, it should probably consider turning exclusively to ice cream.
Along the same vein, the Gobi Ice Cream and Bicycle Co. should probably give up
the ice cream and focus on the product in which it is the least disadvantaged
(bicycles).
What Does Absolute Advantage Mean?
The ability of a country, individual, company or region to produce a good or service
at a lower cost per unit than the cost at which any other entity produces that good
or service.

Investopedia explains Absolute Advantage

Entities with absolute advantages can produce something using a smaller number of
inputs than another party producing the same product. As such, absolute advantage
can reduce costs and boost profits.
What Does Competitive Advantage Mean?
An advantage that a firm has over its competitors, allowing it to generate greater
sales or margins and/or retain more customers than its competition. There can be
many types of competitive advantages including the firm's cost structure, product
offerings, distribution network and customer support.
Investopedia explains Competitive Advantage
Competitive advantages give a company an edge over its rivals and an ability to
generate greater value for the firm and its shareholders. The more sustainable the
competitive advantage, the more difficult it is for competitors to neutralize the
advantage.
There are two main types of competitive advantages: comparative advantage and
differential advantage. Comparative advantage, or cost advantage, is a firm's
ability to produce a good or service at a lower cost than its competitors, which gives
the firm the ability sell its goods or services at a lower price than its competition or
to generate a larger margin on sales. A differential advantage is created when a
firm's products or services differ from its competitors and are seen as better than a
competitor's products by customers.