Economics 101: How to Calculate Opportunity Cost with Dan Egan
- Written by Candice Elliott
We don’t get much personal finance education so we’re doing some economics 101 lessons. Today we discuss how to calculate opportunity cost with Dan Egan.
Dan Egan from Betterment will be our professor today and he’s drinking beer brewed at Betterment!
What is Opportunity Cost?
Opportunity cost is what you give up when you choose between options. No matter what we choose, there is a next best choice that we give up, that is the opportunity cost. We want to minimize our opportunity cost by choosing the option that benefits us most.
We have to weigh opportunity costs because of scarcity. Scarcity means limited resources. All of our resources, time, money, effort, are not infinite and could be used in a variety of ways. So we have to carefully consider our decisions to make sure what we are gaining by making one choice over another is more valuable than what we are foregoing.
Every Day Examples
Opportunity cost sounds very ominous. Like you are really going to be missing out or possibly making a big mistake if you choose wrong. But we make minor decisions every day that involve opportunity costs.
You want to go out to dinner. You decide to go to the French place over the Italian place. The enjoyment of an Italian meal is the opportunity cost of that decision.
You want a new DVD and a new book. You don’t have money for both. You choose the book. Watching the DVD is the opportunity cost.
Of course there are situations where the opportunity cost of a decision are much higher than eating steak tartar instead of pasta. Investing is one area where opportunity costs must be more carefully considered.
You have $10,000 worth of stock you can sell now for $15,000 but if you wait three months, the stock value is expected to increase even more. But you decide to sell now. The opportunity cost is going to be the difference between the $15,000 you got when you sold early and the price the stock would have sold for three months later.
Maybe you would have made even more money, maybe you would have lost money. Opportunity costs aren’t always readily apparent.
Even investment decisions aren’t always just about how much money you stand to make or lose. You are faced with two investments that would both give the same return but one would require your money to be tied up for five years versus two years. The opportunity cost is losing the liquidity of that money for an additional three years.
Perhaps you have to pass up a good investment opportunity during that time because you’re unable to access that money. Maybe you need to pay for something unexpected like a major home repair but that money is tied up and you have to take out a loan to cover it.
Having the money and being able to access the money are two different things.
Implicit and Explicit Costs
There are two kinds of costs that we factor in when looking at opportunity cost; implicit and explicit costs.
Let’s use attending college as an example. The explicit costs of that decision are things like tuition, room and board, and books, things that require a payment.
The time required to attend college is an implicit cost. Implicit costs don’t cost us in terms of having to pay for something and is not always easily calculable. Another implicit cost is the money foregone by choosing attending college over working.
How to calculate opportunity cost is usually measured in terms of dollars but your own feelings and values should play a part in all of your decisions, including financial decisions.
It’s been shown that those who have college degrees make more over their lifetime than those who only have a high school diploma. But what if you really don’t want to go to college? What if the only way you can afford it is to take out a lot of student loan debt (it’s not the only way).
Should you still do it, even if it will make you miserable? Probably not. There are plenty of well paying careers that don’t require a college degree.
Doing nothing is a choice too. Sometimes we are so overwhelmed by choices and information, we are paralyzed and can’t decide so we just stand pat. This can have terrible consequences. We all know how valuable time is when it comes to investing. Doing nothing has an opportunity cost. Not investing early leaves a lot of money on the table.
So how do you get over that paralyzing feeling? Ask yourself three questions.
The number of opportunity costs is almost limitless, a game you could play for hours if you liked really boring games. This can be paralyzing and you don’t need to think so deeply about it. You just have to consider opportunity costs in three areas:
Money: What else could you do with this money?
Time: What else could you do with this time?
Effort: Where else could you spend this effort?
By answering those three questions, you can make the best choice and minimize the impact of opportunity cost.
We hope this little Econ lesson, chock full of real world examples helped fill in the gaps left by our crummy educational system.
River Horse Belgian Freeze: A dark Belgian ale.
Betterment: Invest here and get up to six months free investing.
Flying Fish Red Fish: A West Coast style hoppy ale.