GED Social Studies TestEconomicsMedium
A small business owner is considering expanding their operations by purchasing a new machine that costs $50,000. They have two options for financing: take out a bank loan with a 6% annual interest rate, or use $50,000 from their retained earnings that could otherwise be invested in a low-risk bond yielding 4% annually. What is the opportunity cost for the business owner if they choose to use their retained earnings for the machine purchase?
- AThe $50,000 cost of the new machine.
- BThe potential profit generated by the new machine.
- CThe $2,000 in annual interest that could have been earned from the bond.
- DThe 6% annual interest rate from the bank loan.
Show answer & explanationAnswer & explanation
Correct answer: C. The $2,000 in annual interest that could have been earned from the bond.
Opportunity cost is the value of the next best alternative that was not taken. If the business owner uses retained earnings, the next best alternative was investing in the bond, which would yield 4% of $50,000, or $2,000 annually.
Why the other options are wrong
- A. The $50,000 is the direct cost, not the opportunity cost.
- B. The potential profit from the machine is a benefit, not a cost of choosing that option over another.
- D. The bank loan interest is an alternative cost not incurred if retained earnings are used, not the opportunity cost of using retained earnings.
Opportunity Cost
The value of the next best alternative that must be foregone when making a choice.
- It is not the sum of all alternatives, but the single best one not chosen.
- Applies to individuals, businesses, and governments.
- It highlights the trade-offs inherent in decision-making.
Memory trick: Every choice has a lost gain, that's the opportunity's pain.