When we think of what something costs, the most common number that comes to mind is what's listed on the price tag. Unfortunately, this is only the nominal cost and doesn't fully represent what we're paying for a particular product or service. To understand what we pay for a particular item, we must also take into account what else we could do with this money.
Opportunity Cost Defined
According to Investopedia, opportunity cost can be defined as, "the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action." We'd say that's not a bad definition, but certainly not crystal clear either. For this reason, we'll use a couple of examples to get a better understanding.
Example: Going Back to College
With a rapidly changing job market, many are considering going back to college to pursue a new or better career. The cost of this is usually whatever tuition, books, and fees will amount to. However, that's just the price tag and not the opportunity cost. Let's consider Susan as an example.
Susan is working in an administrative capacity and earning $35,000 annually. She would like to go back to school to obtain an undergraduate degree in business management under the belief that she would be able to move into a management position and make approximately $50,000 each year. She will require only two years of school (she's already obtained a 2-year degree) that will cost $30,000 for tuition, books, and fees.
During this time, she will not be able work. What is the cost of her education?
The simple answer is $30,000 for her college expenses. However, she is also giving up working that will cost her $70,000 in lost wages. As a result, the total opportunity cost is $100,000.
The next logical question is, "How many years will it take to get break even?" Using relatively low interest costs and inflation, it would likely take her seven years to be as well off as if she had continued to work at her lower paying job.
Obviously, this example is dealing with rather large numbers, but what about some of the everyday choices that we make? Do they have opportunity costs associated with them as well?
Example: An Expensive Dinner
Kevin and his wife are foodies and spend around $400 each month eating out at fine restaurants in their area. This is one of their favorite activities, but they're also saving exactly zero dollars each month for their five year old son's college education. Though they've repeatedly stated that funding his education is a major priority, they have yet to set any money aside.
In this example, Kevin and his wife have placed a higher value on eating fine cuisine than on their son's college education, but what is their opportunity cost? To determine this, we need to know what they could do in saving for college versus eating out.
The nominal cost is $400 per month, but the opportunity cost is significantly greater. To calculate the cost of not saving for college, we would need to make some assumptions about where the money would be saved, how it would be invested, what rate of return would be achieved, what inflation would look like, and so on. To make it simple, let's assume the following:
- $400 could be placed in a 529 plan
- A balanced investment portfolio would be used
- Average returns would be 8% annually
- The money would be invested for 13 years
- Inflation would be around 5%
- The money would be withdrawn tax free per 529 plan rules
If this is the case, over the course of one year, the opportunity cost would be $6,922 compared to the $4,800 they're spending on dinners out. To put this as plainly as possible, their choice to eat out instead of set money aside for college costs them $6,922 each year.
Why is it so much more? The answer to that has to do with the fact that they are spending money on something that has no value after it is spent whereas with investing money for college, the money can grow based on the investment returns.
Opportunity Cost Re-Defined
Earlier, we gave you a definition from Investopedia, but after running through these examples, let's state it in more familiar terms. Opportunity cost is best defined as the total cost of your next best option. We all have limited resources and virtually unlimited choice. What you need to do is consider what something costs and how alternative choices stack up. When it comes to buying something that has no lasting value compared to something that will grow over time, you have to really enjoy what you're buying to make up for the difference in opportunity cost.
In our examples, if Kevin and his wife are a happier couple because of their dinners out, maybe that's enough to pickup the difference in cost compared to funding college for their son. If Susan will be made happier by going to school and quitting work, maybe it makes the seven year payback less of an issue. The bottom line with this is we all have to make choices, but taking a serious look at opportunity costs will generally give us the best outcomes.
As we've stated earlier, the study of economics is all about maximizing our happiness and satisfaction in life. Knowing your opportunity costs can help you make better decisions in allocating your time and money which will lead to a greater sense of happiness and satisfaction. If you fail to count the costs, odds are good that you'll wind up feeling the pain from your choices.