Mind Your Decisions

Decision Factor #2: 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

The Economist.com has a nice definition of opportunity cost:

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.

The NFL draft is a popular example where opportunity costs are important. 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. Teams that fail to consider opportunity cost end up with some bad choices, and fans quickly voice their disagreement to management.

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.

If you understand these examples, congratulations! You are now more knowledgeable on this topic than many academic economists. See pages 5-8 of “The Economic Naturalist” (pdf) where over 75% of the surveyed economists could not answer a simple opportunity cost question.