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Definition of Trade-Offs:
are all of the opportunities given up when a choice is made.
We make many decisions every day on how to use our scarce resources such as time and money. All our decisions have trade-offs. For example, what are some of your trade-offs in choosing to go to the movies with your friends? There is the cost: say, $8 for a ticket, $4 for the popcorn and drink, and $1 for the gas to get to the theater. Perhaps you would not be able to go out to eat with your family, or spend the three hours on a paper you really want to get written so you can go horseback riding tomorrow. Each of these is a trade-off. Anything that is given up when you make a decision is a trade-off.
Economists refer to the most valued trade-off, or the next best alternative, as the opportunity cost of a decision. Investors should evaluate their appropriate tolerance to risk before making any investment because there is a trade-off between an investment's risk and potential return. For example, an investment in US Treasury bills is considered risk-free but pays a very low return. Investments in stocks carry a much greater potential return, but also a higher risk of loss. This is a risk-return trade-off. Risk-return trade-offs are not just in investing. For example, shooting a three-pointer in basketball is riskier than a two-pointer, but many coaches believe the risk is worth the potential return if they have a good shooter.
Dig Deeper With These Free Lessons:
Opportunity Cost – The Cost of Every Decision
Production Possibilities Frontier
Fundamental Economic Assumptions
Marginal Analysis – How Decisions Are Made