Wednesday, December 17, 2008

Understanding Opportunity Cost

The opportunity cost of a resource is the value of the next-highest-desired alternative use of that resource. For example, if you spend time and money at a movie, you cannot spend that time at home reading your favorite blog and you cannot spend the money on something else. If your next-best alternative to seeing the movie is reading this blog, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book.

Take a student who pays $4,000 for tuition to Miami-Dade College. Assume that the same student also receives an $8,000 scholarship. Therefore, the cost is $12,000 and the student pays only 1/3 of the total tuition. However, the true cost to the student is $12,000 plus the lost income the student could have earned instead of going to school. If the student could have earned $20,000 per year, then the true cost of a year’s schooling is $12,000 plus $20,000, for a total of $32,000. Of this $32,000 total, the student pays $24,000 ($4,000 in tuition plus $20,000 in forgone earnings). That is the opportunity cost. It's how you could have spent money or time if you had chosen another path.

Incidentally, opportunity cost is not the sum of all the available alternatives when those alternatives are mutually exclusive. So, if the student could have had a choice between the $20,000 a year job or a $50,000 grant to build houses in New Orleans you do not include both in your calculations.

Opportunity cost isn't just measured with money; it can be anything valuable. For example, in a restaurant, the opportunity cost of eating a steak could be trying the salmon. Ordering both meals could cost more than double - not just the extra money to buy the second meal but the cost to your reputation if you appear gluttonous or extravagant for ordering two meals.

Calculating opportunity costs is fundamental to knowing the real cost of anything. When there is no accounting or monetary cost (what accountants say instead of "price") for an action, ignoring opportunity costs may produce the illusion that it's free. These opportunity costs then become the hidden costs which can come back and bite you.

Now, it's time for a reality check. It is possible to take this too far. If you keep mapping out possible alternatives with fanciful opportunity costs you will quickly drive yourself insane. Don't do it! Keep it real and don't go to extremes with this tool.

Opportunity cost is an important tool to help you understand the real costs of any decision. The cost of the alternative use of a resource must always be taken into account when trying to understand the costs of any decision. Opportunity costs are not totally cumulative when examining mutually exclusive options so be careful when listing the alternative uses for resources. Remember, money is not the only resource! Be sure to measure all the resources in use before committing to a course of action. Finally, don't let calculating opportunity costs paralyze your ability to make a decision. Like all tools, opportunity cost is best when used wisely.

Henderson, David R. Opportunity Cost: The Concise Encyclopedia of Economics
Wikipedia: Opportunity Cost