How do you calculate opportunity cost when choosing between investment projects?

The opportunity cost of choosing a project is the value of the best alternative you could have chosen but must now give up. It is not automatically the money spent on the chosen project, or the sum of every rejected proposal.

Suppose a council has enough resources for only one of two infrastructure schemes: a water pipeline or a flood barrier. The table compares their benefits and all relevant costs over the same period, in million currency units. These are present values: future costs and benefits have been converted to their value today. Assume each benefit is separate, with no overlap.

If the council selects the pipeline, the flood barrier is the next-best alternative. A question asking for the benefits forgone gives

$$13+3=16\text{ million}.$$

The 12 million spent on the pipeline is its resource cost; it is not the answer to that benefits-forgone question. Choosing the pipeline means those resources cannot be used to deliver the barrier's benefits.

If the comparison instead values the alternative by its net benefit, subtract its costs from its benefits. The net benefit given up is

$$16-12=4\text{ million}.$$

State which approach the question requires. Gross benefits are measured before subtracting costs; net benefits are measured after. Do not mix the two. The pipeline's extra net benefit compared with the barrier is $7-4=3$ million, which is different again from either opportunity-cost figure.

On these assumptions, the pipeline provides the larger net benefit. That conclusion may change if the estimates are uncertain or important effects are missing from the totals. For example, flood protection may be especially valuable to vulnerable households. Decision-makers may therefore consider who benefits, not just the total value.

To compare projects fairly, cover the same period and use a consistent method of discounting, which converts future values to present values. Include relevant operating costs and avoid counting the same benefit twice. Wages paid to construction workers are not automatically an extra benefit to society on top of the project's output: workers' time is itself a scarce resource.

Finally, imagine a third feasible project would produce a net benefit of 6 million using the same budget. It would replace the barrier as the next-best alternative. The opportunity cost on a net-benefit basis would then be 6 million, not $6+4=10$ million, because both rejected projects could not have been undertaken with that single budget.

Try the rail-and-highway choice in the Economics Foundations Questionbank. Identify the benefits of the option not chosen, then check that your opportunity-cost calculation does not simply repeat the selected project's cost.