Difficulty: Introductory to Intermediate | Prerequisites: Basic understanding of explicit vs. implicit costs
Opportunity cost and sunk cost are the two ideas that separate economic thinking from everyday intuition about money. They appear in nearly every microeconomics exam, and they underpin later topics like production decisions, cost curves, and firm behaviour. If you missed earlier material on explicit vs. implicit costs, review that first.
Every choice has a cost: the best alternative you gave up. That is your opportunity cost, and it is what economists mean when they say "cost." A sunk cost, by contrast, is money already spent that you cannot recover, so it should never influence your next decision. Most exam questions on these topics test whether you can ignore what has already been paid and focus on what the alternatives are worth going forward.
Opportunity cost
The value of the next-best alternative you forgo when you make a choice. In economics, every cost is ultimately an opportunity cost.
Think of it as: whatever you are giving up by choosing this option instead of the next-best one.
Sunk cost
A cost that has already been incurred and cannot be recovered, regardless of what you do next. Sunk costs should be irrelevant to forward-looking decisions.
In simple terms, this means: money already spent is gone. Do not let it trap you into sticking with a bad decision.
Economic profit
Total revenue minus all costs, including both explicit costs (actual payments) and implicit costs (opportunity costs of owner-supplied resources).
Think of it as: the profit left over after accounting for everything you could have earned doing something else with your time and money.
Implicit cost
The opportunity cost of using resources the firm already owns, such as the owner's time or the owner's capital.
In simple terms, this means: just because you do not write a cheque does not mean there is no cost. Your time and your money could be earning returns elsewhere.
Farmer Jones bought his farm for $75,000 in 1975. Today it is worth $500,000, and the interest rate is 10%.
ABC Corporation offers $500,000 today. XYZ Corporation offers $530,000 one year from now. Farming the land this year yields $15,000 net profit.
The correct decision: sell to ABC Corporation today.
Why? If Jones sells for $500,000 today and invests at 10%, he has $550,000 in a year. Compare the alternatives:
Sell to ABC now, invest: $550,000 in one year
Sell to XYZ in one year: $530,000 + $15,000 farming profit = $545,000 in one year
The opportunity cost of waiting is $550,000. Waiting only yields $545,000. Selling now is worth $5,000 more.
Notice that the original $75,000 purchase price plays no role. It is a sunk cost.
Constantine bought 100 shares of IBM at $150/share. The price has fallen to $55/share.
He refuses to sell until the price returns to $150, because he does not want to "buy high and sell low."
This reasoning is incorrect. The $150 he originally paid is a sunk cost.
The only relevant question is: given that the shares are currently worth $55 each, what is the best use of that $5,500 going forward? Whether he originally paid $150 or $15 per share changes nothing about the decision he faces today.
Opportunity cost of an action = Value of the best forgone alternative
Economic profit = Total revenue - Explicit costs - Implicit costs
Decision rule: Compare the total value of each option going forward. Ignore any costs already incurred. Choose the option with the highest net present value.
For the Farmer Jones problem, the comparison framework is:
Option A value in one year = Sale price today x (1 + interest rate)
Option B value in one year = Future sale price + Net farming profit
Choose whichever is larger.
Opportunity cost is why economists say there is no such thing as a free lunch. Even if you get a meal without paying, you spent time that could have been used elsewhere. In business, opportunity cost drives decisions about whether to expand, pivot, or shut down: the question is never "are we making money?" but "are we making more money than we could be making doing something else?"
The sunk-cost fallacy explains why people sit through terrible films they have paid for, why governments pour money into failing projects, and why investors hold losing stocks too long. Recognising sunk costs is one of the most practically useful things you take from this course.
Students often think the purchase price of an asset matters when deciding whether to sell. It does not. The purchase price is sunk.
Students confuse accounting profit (revenue minus explicit costs) with economic profit (revenue minus all costs, including opportunity costs). A firm can have positive accounting profit and negative economic profit.
Students sometimes think opportunity cost only applies to money. It applies to time, effort, and any scarce resource.
Students assume that if something is "free" (no monetary cost), it has zero opportunity cost. It almost never does.
Exam questions frequently set up a scenario where someone is holding an asset and ask what they should do. The trap is using the original purchase price in the calculation. Ignore it.
Present-value and future-value comparisons are common. Make sure all options are compared at the same point in time (either all in today's terms or all in one year's terms).
The distinction between economic profit and accounting profit is a common multiple-choice topic.
True or False: The price you paid for a concert ticket should influence whether you attend the concert if you feel ill.
Fill in the blank: Economic profit equals total revenue minus explicit costs minus ______.
True or False: A firm with positive accounting profit must also have positive economic profit.
Fill in the blank: The opportunity cost of farming your own land for a year includes the ______ you could have earned by selling the land and investing the proceeds.
True or False: If Farmer Jones's farm had originally cost $500,000 instead of $75,000, his decision should change.
Answers:
False. The ticket price is a sunk cost.
Implicit costs (opportunity costs).
False. Implicit costs might exceed the accounting profit.
Interest (or return on investment).
False. The original purchase price is irrelevant.
Q: Farmer Jones's farm is worth $500,000 today, the interest rate is 10%, and he can earn $15,000 net profit by farming this year. XYZ offers $530,000 one year from now. What should he do, and why?
A: Sell today and invest the $500,000. In one year he would have $550,000. Waiting yields only $530,000 + $15,000 = $545,000. Selling now is better by $5,000. The original $75,000 purchase price is a sunk cost and irrelevant.
Q: Constantine bought IBM stock at $150/share. It is now $55/share. He refuses to sell until it hits $150 again. What error is he making?
A: He is committing the sunk-cost fallacy. The $150 purchase price is sunk and should have no bearing on whether to hold or sell. The only relevant question is whether $55/share represents good value going forward compared to alternative investments.
Q: What is the difference between economic profit and accounting profit?
A: Accounting profit = revenue minus explicit costs (wages, rent, materials). Economic profit = revenue minus explicit costs minus implicit costs (opportunity costs of the owner's own resources). Economic profit is always less than or equal to accounting profit.
Opportunity cost connects directly to the theory of production and cost curves later in the course. When firms choose how much labour and capital to use, they are comparing the opportunity cost of each input. It also underlies comparative advantage in trade theory: countries specialise in what they produce at the lowest opportunity cost.
Sunk costs reappear in game theory and strategic decision-making, where the ability to commit resources (making them sunk) can be a strategic advantage.
Related Terms / Search Tags
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