Understanding opportunity costs

Two roads diverged in a wood, and I–I took the one less traveled by, And that has made all the difference–Robert Frost

Opportunity cost is one of the most important concepts. Opportunity cost is the true way to measure the cost of something you are doing.

To be specific, let us read the definition of opportunity cost at The Economist.com:

The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (UTILITY) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else.

Opportunity cost factors into every decision you make. Consider the decision to buy a high-end TV. The simple cost is the cash outlay of hundreds or thousands of dollars. But this does not reflect the true cost.

The true opportunity cost is all the things you could have done with that money instead. You could have gone to a lot of movies. You could have bought your friend a gift. You could have invested in stocks. You could have paid off loans. When you take these factors into account, it is apparent that buying a TV you don’t need is a very costly adventure indeed.

The NFL draft and opportunity cost

Opportunity cost is not a trivial concept. In fact, it is useful even in big decisions like the draft in the NFL. The draft is set up where draft picks are chosen sequentially, with each team having a set time to make a decision. Teams not only consider basic things like holes in the roster and which players are remaining, but they also consider possible alternatives–like choosing another player OR considering trades from other teams.

Teams make mistakes when they pick a player too early–if they could have gotten the same player in a later round–or when they do not accurately gauge the value of their high pick to another team. In the 1998 draft, busts such as Curtis Enis and Ryan Leaf become even worse when those teams could have had future Pro-Bowlers Randy Moss or Alan Faneca.

My own experience

Here’s a personal example of opportunity costs. I typically cook at home because its enjoyable, healthy, and less costly. While it does take extra time to cook and clean, I am happy since I prefer the total experience to the alternative (opportunity cost) of dining out frequently. You may not feel the same way: I have an unusual preference for making my own food.

But there is one time I eat out more often: when friends visit me from out of town. In this situation, spending time with guests is the most important factor, and cooking and cleaning at home reduces quality time to catch up. In this case, the opportunity cost of cooking has increased to a point where I am willing to spend a little more and eat a couple unhealthy meals.

It’s a hard concept!

It is not the easiest thing to understand opportunity cost. For instance, a survey explained in pages 5-8 of “The Economic Naturalist” (pdf) demonstrates that over 75% of professional economists could not answer a simple opportunity cost question. So if you understood the examples that I’ve described above, then give yourself a pat on the back. You are well on your way to making smart decisions.

When has opportunity cost affected your decisions? How do you estimate opportunity cost?

This post is part 3 of a 7-part series on the most important lessons in personal finance. Here are links to all of the articles in the series:

1. Personal finance is not about money
2. Know your preferences
3. Consider opportunity costs
4. Calculate risk
5. Know the time value of money
6. Consider taxes
7. Know the value of your time