Opportunity Cost

What is  Opportunity Cost ?

Opportunity Cost is the foregone benefits of the next best alternative. For instance, the opportunity cost of a bank lending to the borrowers is usually ZERO all the time. Hence, it is better or cheaper for a bank or a financial institution to lend money out other than keeping the cash in their cash box (i.e idle money).

Opportunity Cost applies in decision making where resources to be utilized are limited in supply.

Opportunity Cost is required when management is identifying the optimal decision to make in investment.

How does Opportunity Cost work?

Opportunity Cost works in an off-setting manner where by one has to forgo one option to get the other.

Illustration of Opportunity Cost

Case One: Commercial banks

Commercial banks main source of income is interest charged on loans advanced to customers. The banks have to make a decision to either

  1. Lend loans at 16% of the principal amount

                                   OR

  2. Keep the cash in safe custody in their premises (ie this is idle money with 0% interest)

FURTHER ANALYSIS OF THE TWO BANK OPTIONS

If the bank opt not to lend the cash, the money will remain in the cash box with zero (0%) interest. In other words, the choice made will make the bank forgo the 16% interest on principal amount.

So, the opportunity cost of not lending money to the customers will be the forgone benefit of 16%. This is a very costly decision to make.

If the bank opt to lend the cash, the money will attract an interest of 16% of the principal amount. In other words, the choice made will make the bank forgo 0 % interest on principal amount.

So, the opportunity cost of lending money to the customers will be the forgone benefit of 0%. This is a very cheap decision to make.

CONCLUSION

So, why do banks go looking for customers to issue loans to? Is it because they will reap a 16% interest as per our example?

The answer is NO. The reason is because they fear remaining with their cash in the cash box for in such a case, they will forgo a 16% interest they could have gotten if they gave out loans.

In conclusion, the reason why bank managers spend sleepless nights thinking of who next to issue with loans is because the OPPORTUNITY COST of lending loans is very low (0%-zero)