Understanding the two economic concepts in layman’s terms
We are often perplexed by the choices we ought to make. Party hard or study for hours? Start a business or stay in a well-paid job? Although these are binary choices, life is full of choices that go beyond being binary. Instead, there exists a spectrum of choices. Choices are essentially trade-offs we have to make in choosing one over the other(s).
Related to trade-offs is the concept of opportunity cost. Consider the following anecdote:
“Afreen goes on shopping. She stops by a clothing store and decides to shop there. She selects five dresses: A, B, C, D, and E. However, Afreen has a limited budget and can only afford one right now. She now faces a paradox of choice — a psychological phenomenon. Afreen decides to scrap three of five selections: A, B, and C. Now, only two options remain with her: D and E. Afreen finally selects E, pays for it and leaves the store.”
The above can be summarized as follows:
- Shortlisted choices: A, B, C, D, E
- Choices immediately discarded: A, B, C
- Options remaining: D, E (Binary)
- Final selection: E.
Trade-offs refer to all options discarded in favor of one. Hence, A, B, C, and D are trade-offs in the above example since Afreen discarded them in favor of E.
However, opportunity cost refers to the second-best alternative discarded in favor of one. In the above example, Afreen chose E over D when left with the two options. Hence, D is the opportunity cost in this case.
Do you remember in the opening paragraph, we saw examples of binary choices. The opportunity cost arises when choices face reduction to being binary (two options). In the opening example paragraph of party hard or study for hours, studying for hours costs you missing the opportunity to party and vice versa.