Doing one thing means giving up on another. Opportunity cost is about tradeoffs: comparing an option against its alternatives to decide the best use of scarce resources.
The adage “there is no such thing as a free lunch” summarizes the concept of opportunity cost well.
To make it more vivid, imagine buying a car. You now have a few choices:
- Use the car to transport yourself.
- Rent the car out.
- Share the car with a loved one.
To decide its optimal use, we have to compare these options against each other.
Renting the car out means an additional income. Let’s say $25 per day. But in that case, you’ll have to use another way to travel around yourself. If the travel costs are below $25, renting it out becomes profitable. On the flip side, if your travel costs are above $25, you’d be making a loss.
The above example doesn’t take into account non-monetary resources such as time. Renting the car out may be profitable, but if as a result of that you spend another 1 hour every day commuting to work, is the extra money worth “losing” 1 extra hour?
Now compare using the car yourself versus sharing it with a loved one. In the latter case you share the expenses – saving yourself money – but do so at the cost of using the car whenever you want to. Of course, you can mitigate the “loss” of flexibility by scheduling who can use the car at which time and finding the optimal balance between costs and benefits for both. Sharing a car may also improve the relationship you have with a loved one because it provides him/her with more options (more distant job opportunities, more distant options for dates, etc).
While opportunity cost is often applied to comparing choices on the basis of money, it applies equally to any other scarce resource such as time or relationships.
When making a decision based on opportunity costs, you incorporate both explicit and implicit costs.
Explicit costs are the direct costs of action – those that are easily identifiable and often involve a transfer of money. For example, if a person leaves work for an hour and spends $200 on office supplies, the explicit (opportunity) costs are the total expenses for the office supplies of $200.
Contrast this with implicit costs: the intangible and often hidden costs of an action. In the above example, the implicit cost is the time the person spent away from his/her work (1 hour). If he/she earns $25 per hour, the total opportunity cost would be $200 + $25 = $225.
If that person is a salesperson and would usually close 1 deal worth $1000 in an hour, now you’re looking at a total opportunity cost of $200 + $25 + $1000 = $1225…even though you only “spent” $200 on office supplies.
The above example involves a human, but the same logic can be applied to infrastructure, like buildings, roads or land. A building can be used as:
- Own home
- Home for others (rent out)
- Storage space
- Office space
- Gallery
- Shop
Each of the above options has its own monetary and non-monetary costs and benefits. With opportunity cost, you compare each option to one another and pick the one that provides the biggest overall “benefit.”
As the future is uncertain, opportunity cost is best used in combination with:
- Probabilistic thinking: to create an expected value for each option
- Arbitrage: to find ways to increase the gap between potential upside and downside, thus changing the expected value for an option
Remember one thing: opportunity cost-based decisions are only necessary in environments where resources are scarce. If scarcity doesn’t exist, every option can be satisfied as none prevents the pursuit of the other.
One major flaw opportunity cost helps overcome in decision-making is that of sunk costs. These are costs that have already been incurred and cannot be recovered. These should not influence present or future actions or decisions but often do. Opportunity cost, on the other hand, is forward-looking and unaffected by sunk costs, providing an unbiased “optimal” solution based on present circumstances.
To illustrate this: how often have you been involved in a business project that went on too long and ultimately failed? Decision-makers, in this case, often fell into the trap of thinking in terms of sunk costs and not wanting to let their investment go to waste.
Thinking in terms of opportunity costs does not prevent future failure, but it does give you the best odds of success. You’d do yourself a favour to compare your options against their alternatives.
How to use Opportunity Cost
In investing, you deploy your capital to (hopefully) earn a positive future return in line with the risk you take on. The problem here is that many focus on “should I invest in this yes or no,” making their decision binary and ignoring their alternative options.
Do yourself a favour and compare your investment to every alternative investment option at your disposal from now on, without forgetting your circle of competence.
With jobs, the job you’re currently at may pay you $100,000 per year, while a competitor comes in and offers you $150,000 per year to switch. Making your decision solely based on income, instead of opportunity cost, can come at the expense of your well-being and future opportunities.
For example, if your new job forces you to move to the middle of nowhere, you may have a more peaceful life, but lose the serendipitous moments that cities bring (meeting strangers). Similarly, at your current job, you may love the work environment and people you’re with and are able to challenge and develop yourself every day. Not to mention you could’ve tried to renegotiate with your current employer and gotten a raise, stock options, promotion or the dream job you’ve desired.
Lesson: consider all your options.
In relationships, you can only invest your time in a limited number of relationships. Not only the number, but also the depth of the relationship: investing in one comes at the expense of another. This is especially true for marriage in monogamous societies: you choose one life partner over the alternative partners. Once you marry, you effectively take yourself “off the market.”
In time, ask yourself: does it make sense for you to do these activities yourself or to let someone (or something) else take care of them?
Mowing one’s own lawn may make sense for a retiree or a child earning some pocket money, but it may not make sense for an active doctor or lawyer whose time is scarcer (thus more valuable and with higher opportunity costs).
With health, going to work while feeling unwell allows you to earn money (and possibly status) that day, but comes at the expense of your health.
We often see this in sports when athletes play with/through injuries. While performing in the present, they risk aggravating their injury and being out for a longer period of time or having long-term health problems.