opportunity costs
Ahh the beautiful opportunity cost. The definition that changes your entire perspective of the world.

One day you are making decisions impulsively without consideration of later effects. And then you learned about this definition.

And you learn how to see the world with whole new eyes.

The most basic definition of opportunity cost is the price of the next best thing you could have done had you not made your first choice. Opportunity costs include both explicit and implicit costs.

Explicit Costs

Explicit costs are direct, out-of-pocket payments such as wages, utilities, materials, or rent. If you own a restaurant and you add a new item to the menu that requires $30 in labor, ingredients, electricity, and water, your explicit cost is $30. Your opportunity cost is what you could have done with that $30 had you not decided to add the new item to the menu. You could have given that $30 to charity, spent it on clothes for yourself, or added a different menu item.

Implicit Costs

Implicit costs do not represent a financial payment. Instead, implicit costs concern resources you already own. It’s not a direct cost to you, but rather the lost opportunity to generate income through those resources. If you have a second house that you use as a vacation home, for instance, the implicit cost is the rental income you could have generated if you leased it to tenants and collected monthly checks (instead of using it for your own family). It doesn’t cost you anything upfront to use the vacation home yourself, but you are giving up the opportunity to generate income from the property.

Beyond Business

Although the concept of opportunity cost is heavily rooted in economics and finance, opportunity costs should also include your personal feelings and values. For example, if you love to cook, you shouldn’t become a doctor instead of a chef simply because doctors earn more money than chefs. The opportunity cost of becoming a doctor in this scenario would be to deny yourself the opportunity to do what you truly love.

Furthermore, you can drive yourself nuts thinking about all of the things that could have happened if you had made different choices. What if you hadn’t gone to the party where you met your spouse? What if you had bought into that financing deal that turned out to be a scam? What if you had gone to Stanford and become best friends with two now-billionaire technology giants? You could go insane trying to figure out all of the things you could have done, so decisiveness is still a virtue.

The goal of studying the concept of opportunity cost is not to make yourself constantly second guess your actions or strategy, but to make sure you are cognizant that your choices do have consequences. Always consider the opportunity cost, but once you’ve made a decision, have faith in that decision.

Opportunity Cost Is Closely Related to Trade-Offs

If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that nearly every decision requires a trade-off. We live in a finite world—you can’t be two places at once. That means if you choose one restaurant tonight, you can’t choose another. There are trade-offs involved in that decision, including the relative distance and travel time required to reach the establishment, the price of the menu items at each, the level of service, the type of cuisine, and the speed with which the food is brought to your table.

Even at this moment, you are reading this article when you could have been golfing, writing, exercising, serving at a food bank, or jumping on a plane to a new country. To the extent factors can be controlled, your life is the sum culmination of your past decisions. That, in a nutshell, is the definition of opportunity cost.

On some level, this is common sense stuff that economists like to make difficult. All you have to do is ask yourself:

  • What if Walt Disney had never started animating?
  • What if Elton John had never composed songs?
  • What if Warren Buffett had given up when he was rejected from Harvard Business School?
  • What if Thomas Edison had stopped working on the light bulb when he failed the first few thousand times?
  • What if Michael Jordan stopped playing basketball when he was cut from his high school team?
  • What if Steve Jobs had never returned to Apple to lead its resurgence, fundamentally reshaping the future of technology?

via What Is Opportunity Cost? – The Balance

Investors are always faced with options about how to invest their money to receive the highest or safest return. The investor’s opportunity cost represents the cost of a foregone alternative. If you choose one alternative over another, then the cost of choosing that alternative becomes your opportunity cost.

Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well. Businesses will consider opportunity cost as they make decisions about production, time management, and capital allocation.

A simple way to view opportunity costs is as a trade-off. Trade-offs take place in any decision that requires forgoing one option for another. So, if you chose to invest in government bonds over high-risk stocks, there’s a trade-off in the decision that you chose. Opportunity cost attempts to assign a specific figure to that trade-off.

How Do You Calculate Opportunity Cost?

An investor calculates the opportunity cost by comparing the returns of two options. This can be done during the decision-making process by estimating future returns. Alternatively, the opportunity cost can be calculated with hindsight by comparing returns since the decision was made.

The following formula illustrates an opportunity cost calculation, for an investor comparing the returns on different investments:

Opportunity cost formula

How Opportunity Cost Works

Investors try to consider the potential opportunity cost while making choices, but the calculation of opportunity cost is much more accurate with the benefit of hindsight. When you have real numbers to work with, rather than estimates, it’s easier to compare the return of a chosen investment to the forgone alternative.

For example, imagine your aunt had to decide between buying stock in Company ABC and Company XYZ. She chooses to buy ABC. A year later, ABC has returned 3%, while XYZ has returned 8%. In this case, she can clearly measure her opportunity cost as 5% (8% – 3%).

Opportunity cost is often used by investors to compare investments, but the concept can be applied to many different scenarios. If your friend chooses to quit work for a whole year to go back to school, for example, the opportunity cost of this decision is the year’s worth of lost wages. Your friend will compare the opportunity cost of lost wages with the benefits of receiving a higher education degree.

You can also consider the opportunity costs when deciding how to spend your time. Say that Larry, an attorney, charges $400 per hour. He decides to close his office one afternoon to paint the office himself, thinking that he’s saving money on the costs of hiring professional painters. However, the painting took him four hours, effectively costing him $1,600 in lost wages. Let’s say professional painters would have charged Larry $1,000 for the work. That means Larry’s opportunity cost was $600 ($1,600 – $1,000).

You chose to read this article instead of reading another article, checking your Facebook page, or watching television. This choice resulted in a trade-off. Your life is the result of your past decisions, and thatessentially, is the definition of opportunity cost.

Limitations of Opportunity Cost

The primary limitation of opportunity cost is that it is difficult to accurately estimate future returns. You can study historical data to give yourself a better idea of how an investment will perform, but you can never predict an investment’s performance with 100% accuracy.

The consideration of opportunity cost remains an important aspect of decision making, but it isn’t accurate until the choice has been made and you can look back to compare how the two investments performed.

While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can’t be assigned a dollar amount. Say you have two investment opportunities. One offers a conservative return but only requires you to tie up your cash for two years, while the other won’t allow you to touch your money for 10 years, but it will pay higher interest with slightly more risk. In this case, part of the opportunity cost will include the differences in liquidity.

The biggest opportunity cost regarding liquidity has to do with the chance that you could miss out on a prime investment opportunity in the future because you can’t get your hands on your money that’s tied up in another investment. That’s a real opportunity cost, but it’s hard to quantify with a dollar figure, so it doesn’t fit cleanly into the opportunity cost equation.

Key Takeaways

  • Opportunity cost measures the impact of making one economic choice instead of another.
  • While it’s often used by investors, opportunity cost can apply to any decision-making process.
  • Opportunity cost can be considered while making decisions, but it’s most accurate when comparing decisions that have already been made.

via Opportunity Cost: What Is It and How to Calculate It

 

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