Definition
Think of picking between two dishes at a restaurant, like fried noodles or spicy seafood noodle soup. We're choosing things all the time. When you choose one option, you have to give up others. The most valuable one you give up is called the opportunity cost. It covers more than money. The time and effort you put in, which you can't see, count too.
Why is there no such thing as a free lunch?
Imagine a friend gives you a free movie ticket and you go to the theater. You didn't pay a cent, so it feels like you saw the movie for $0. But look at it through an economist's eyes, and it's not free at all. During those 2 hours, you could have rested at home. Or you could have worked a part-time job at 10,000 won an hour (about $7) and earned 20,000 won (about $14).
So whenever you do something, count not only the money leaving your wallet, but also the value of the time you give up. Behind every visible price tag sits the value of the other things you could have done with that time.
All resources and time in the world are limited. To hold one thing, you have to let go of another. The famous saying "There's no such thing as a free lunch" is about exactly this idea of opportunity cost.
How to count when you give up several things
What if you decide to study on a weekend afternoon? In that time, you could have played games with a friend. You could have taken a nap. You could have watched a movie. When you give up several options like this, is the opportunity cost all of them added together?
No, it isn't. You only have one body. Even if you hadn't studied, you couldn't have played games, napped, and watched a movie all at once. So of all the options you gave up, you count only the single most valuable one as the opportunity cost.
Say gaming would have been worth 50,000 won of fun to you, a nap 30,000 won, and a movie 20,000 won. Your opportunity cost is the biggest one, 50,000 won. It isn't the total of everything you gave up. It's the top-ranked option that hurts most to miss.
A little more precisely: money you see and money you don't
To be a little more precise, opportunity cost is the visible costs and the invisible costs added together. In economics, the money that actually leaves your wallet is called an "explicit cost." The benefit you gave up, which you can't see, is called an "implicit cost."
For example, say you pay 10 million won (about $7,000) in tuition for a year of college. The real cost of going isn't just that 10 million won. If you had skipped college and worked at a company for that year, you would have earned a salary of 25 million won (about $18,000). You gave that up too.
So the real opportunity cost of one year of college is the 10 million won tuition plus the 25 million won you could have earned, which makes 35 million won (about $25,000). To make a smart choice, you need to check carefully for the hidden costs that never leave your wallet.
Common misconceptions
Opportunity cost means only the money you actually spent on your choice.
It includes the money you actually paid (explicit cost), and also the value of the other opportunities you had to give up because of that choice (implicit cost).
If you gave up three alternatives, the opportunity cost is the value of all three added up.
You can't make several choices at the same time. So only the one most valuable alternative among those you gave up counts as the opportunity cost.
Where you meet it
When you start a business, the opportunity cost includes not just the shop rent, but also the salary you gave up by quitting your job.
If you choose to sleep in on the weekend, the opportunity cost is the enjoyment you could have had by working out or meeting friends.
If you keep cash in a drawer at home, the opportunity cost is the interest you would have earned by putting it in a savings account.
In one sentence
When you make a choice, opportunity cost is the value of the best option among those you give up, the one that hurts most to lose.