exploring opportunity cost

Opportunity cost is a fundamental economic concept that affects our everyday lives.

Opportunity cost basically refers to the opportunity that you forgo by making one decision over another. Despite it being an economic concept (and being a ‘cost’), the opportunity cost of a decision doesn’t necessarily have to be financial. In fact, we weigh up opportunity cost (often unconsciously) all the time when making decisions:

• Do I eat the chocolate cake or stick to my diet? If I choose to eat the cake the benefit is immediate (pleasure) the opportunity cost may be weight loss.
• Do I hit the snooze button (more sleep) or get up and meditate (better health)?
• Do I buy convenience food (save time) or cook from scratch (save money)?
• Do I work longer hours (money) or spend more time with the family (relationships)?
• Do we get a bigger house with a bigger mortgage (pleasure) or do we live here on one income and stay at home to raise the kids (family)?
• Do I buy a latte or save money?

When making decisions (especially large decisions) it is important to weigh up the opportunity costs of taking one course of action over the other to ensure that you’re aiming for the best possible outcome.

The benefits and the costs of a decision are quite personal. Optimally, a decision is based on personal circumstances, goals and values. For this reason, you can’t really assess the opportunity cost of a decision without really knowing what is important to you, what your values are and what your goals are.

However, more often than not, we make decisions without weighing the economic cost and we are often driven instead by the emotion of the moment. What we want to avoid is making the ‘wrong’ decision, and by wrong I don’t mean by someone else’s standards, but wrong because you come to regret it later.

Everyday decisions like ‘should I really be buying that KFC’ aren’t something that you’re going to be deliberating on for hours, but for big financial decisions, it can be very helpful to write down not only the pros and cons of each option, but the opportunity cost – what you’ll be missing out on if you choose the other option. Then decide if this cost is worth it to you.

A case study

Joe has been saving hard to buy a new car. He has saved $15,000 dollars for the purchase.

Joe has several options at this point:

1. Buy a car for $15,000
2. Buy a used car for less and save / invest / spend the difference
3. Keep the car he has now and save / invest the $15,000 and reap the passive income

Of course there are many other options, such as financing, but these are the ones that Joe has narrowed down to.

So which option should he choose? At the end of the day, it will depend on Joe’s circumstances. Remember, he really, really wants that brand new car.

An opportunity cost of purchasing the new car is that he will lose the potential future income from investing his hard earned cash.

On the other hand, if he chooses to save the entire amount, he forgoes the pleasure he will derive from something that he really wants.

What is the opportunity cost of choosing option two – to buy second hand? The used car may not be as fuel efficient or economical to run (needs extra servicing) and any passive income earned on the amount saved may be swallowed up in car running costs, foregoing the opportunity to build his savings back up again in the future.

Joe decides that his desire for the car outweighs his desire for investing, he reckons that he’s young and can save up again fairly easily for other things. He may even invest the difference he will get for a trade in.

Is this the wrong decision? Maybe for me it would be, personally I would choose option two considering our personal circumstances. However, for Joe, he is happy foregoing the alternate opportunities.