Understanding Opportunity Cost

Many times, when I help someone with their finances, I discover that their biggest obstacle is that they don’t understand opportunity cost and the impact it has on personal finance. In order to take advantage of an opportunity, something else must always be given up. Opportunity cost is basically what you lose by choosing one opportunity and giving up the next best choice. For a basic example, let’s say you can choose between buying a meal out or putting $20 in savings. Each choice has benefits and drawbacks. If you choose the meal, you will likely have a good time, eat good food, and get a chance to relax. If you choose to save the money, you give up that good time and good food, but you get the chance to earn interest on that $20, giving you more money in the future. Either way you stand to gain something and lose something: Gain a good time, lose the interest that $20 could have earned. Gain interest (hopefully) on $20, lose that good time. Every time you make a choice, you’re weighing the opportunity cost of that action.

Opportunity cost is even more important when you face big financial decisions. Rent a home or buy one? One comes with the potential to gain value as an investment, but it also comes with added responsibility and expenses. The other will not gain value but will require less time and money over time. Your opportunity cost here is the loss of potential investment gains if you rent versus the loss of time and additional money you incur if you buy.

Go to college or go straight into the workforce? One will be very expensive, but will hopefully yield higher earnings over time. The other choice lets you start earning money immediately, but you may come to a point where your earnings cannot increase without that degree. Your opportunity cost here is the loss of potentially higher earnings if you go to college versus the four years of additional income you will make if you don’t go to college. In any situation, which one you choose depends on how much you value the opportunity that you choose versus the one you must give up.

Normally all this goes on unconsciously. You may get out the paper and pen and make pro and con lists when faced with big choices like buying a home, starting a business, or going to college, but most of our day to day decisions aren’t made with a full appreciation of opportunity cost. We just look at the checking account, see that we have money and buy the new shirt or go out to eat. We don’t think about the things that we must give up when we make those decisions. In fact, most of us aren’t even aware that we are giving anything up. If the money is there, it must be for spending, right? Anything else that that money could do for us seems so far in the future it doesn’t register.

And this is where financial problems begin. Sure, sometimes you just really, really want that particular shirt or handbag. And it’s okay, within reason, to give in to those desires occasionally. If you’re certain that the handbag or shirt is worth more to you than the interest you could earn, the investment you could make, or the other things you could do with that money, then you’re making the decision that’s right for you. Sometimes the things you want in the here and now are worth more to you than future earnings or purchases. (Although you might not see it that way in ten years, but that’s another story.) And that’s okay. If you only look toward the future, you’ll miss out on a lot of things that are fun in life today.

The problems begin when you never look at what else you could do with your money. When you buy things blindly or make big life decisions without considering the opportunity cost, you’re likely to find yourself making decisions where the opportunity cost doesn’t come out in your favor. Let’s say you decide to buy a home. You’ve considered the pros and cons and you decide that the potential upside of buying is worth more to you than any upside that renting could bring. Great. So you start looking at houses. You decide to buy one that’s about $50,000 more and 1,000 square feet more than you originally planned on. The bank will give you the money, so it’s no problem, right? You know that buying is the better choice for you, so you get ready to make the purchase.

Stop. Consider what you’re giving up if you choose that bigger, more expensive house. You will be giving up lower utility bills, lower monthly payments, lower insurance costs, lower taxes, and lower maintenance costs. You might be giving up the chance to pay off the mortgage in fifteen years versus thirty, which could save you tons on interest and give you the chance to do even more with your money. The bigger house will give you more space and possibly a larger investment return, but are those potential upsides worth more than the other additional costs you will incur? You may decide that indeed they are and go ahead and buy the bigger house. Or you may decide to go with a smaller one. Either way, awareness of the opportunity cost of the choice you must give up will generally yield better financial decisions than making blind assumptions.

It sounds like a drag to think about opportunity cost every time you want to buy a candy bar or some shoes, doesn’t it. But that’s exactly what you have to do in order to make the best use of your money. You cannot go through your financial life on autopilot, assuming that the choices you make today don’t have costs in the future. You have to understand that when you purchase one thing, you are giving up other choices that might have been better. While you can’t know everything that will happen in the future, you can have a good general idea of the impact your choices will have. The good news is that once you practice being conscious of the opportunity costs for awhile, it becomes easier and more subconscious. You don’t have to actively think about the tradeoffs of your choices as much. You will eventually be able to make decisions that take those costs into account without it being a big production. And that’s when your financial life will start to take off.

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2 Responses to Understanding Opportunity Cost

  1. TP says:

    Thank you for this excellent analysis! This helped me to understand opportunity cost for my exam. Your examples were very helpful.

  2. AC says:

    These were fantastic examples that really brought Opportunity cost into light for me. Thank you!

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