You may be asking yourself, “Why does this term sound so familiar?” Shame on you for not remembering this concept from your economics class! I’m just kidding, I’d actually be very impressed if you were still familiar with this concept in a time where older information has a high turnover in our memory to make room for new information.
I will say, if you retain one thing about economics please make it this. This is one concept has the potential to provide abundant value over your lifetime. Once learned and mastered, this is a concept you’ll use every day, most likely multiple times.
Okay let’s get to it, so what’s opportunity cost? Opportunity cost is simply this: the cost of forgoing an alternative in order to pursue a specific action. Put another way: the benefit you COULD have received should you have chosen a different course of action.
Opportunity cost is the reason that many of us continued our education after high school. The rationale is that the cost incurred by not furthering education, in the form of lost wages over a lifetime or job preference, far outweighs the cost of going to college, vocational school, or other higher educational institutions. It was seen as too costly to immediately enter the workforce upon graduating high school without adding to our education and skill set.
Explicit & Implicit Costs
Opportunity costs consist of both explicit and implicit costs. They are very distinct from one another.
An explicit cost is the direct monetary payment for something. This cost directly affects the bottom line of your personal finances. Explicit costs represent clear and obvious cash outflows. Let’s take a look at a couple examples:
- You decide to purchase the newest iPhone priced at $400. Because you spent the $400 this represents a lost opportunity to purchase other things with that $400.
- You are grocery shopping and you decide to get the name brand flu medicine which costs $10 more than the generic brand which has the same active ingredients. Your explicit opportunity cost is the additional $10.
- One note about explicit costs, it’s often to your advantage to know your alternatives as well as the cost associated with those alternatives.
You probably can associate with this cost the most as it appeals to our consumeristic nature.
An implicit cost, also known as an imputed or implied cost, is the cost incurred by the failure to allocate resources to the best alternative use. These costs are a little harder to quantify as they are typically intangible. Examples of implicit costs could include our time or property we own. Here are some examples:
- It’s Saturday and you have the option to watch Netflix all day or work all day instead. By choosing Netflix the implicit opportunity cost is the forgone opportunity to earn a day’s wages because you didn’t allocate your time towards work.
- You have a spare bedroom in your house that you own. Instead of renting it through Airbnb for $80 a per day you allow it to sit empty. Your implicit opportunity cost is $80 per day that it could be generating income yet it’s forgone.
- A note about implicit costs, this requires us to be knowledgeable about the value of the resource in question. In the above examples, we would need to know how much our time costs as well as the cost to rent out a spare room.
You may already be subconsciously analyzing the different explicit or implicit costs during the decision process. That’s good. However, I challenge you to be aware of all your alternatives as well, this is the hard part. It’s difficult because society has told us, and marketed to us, that there are only specific ways to do or fix things. This isn’t true in the slightest sense. They’re concerned with their bottom line, not your well-being. Don’t settle, disrupt the status quo. If there isn’t a better solution, make one.
I do want to take a minute to note that there are many online calculators that will help you estimate a more accurate figure of what your time is truly worth. It’s not always as simple as saying, “My time is worth $X because that’s what my employer will pay me.”
I encourage you to do a little experimental research to determine how much your time is worth. It becomes extremely important for ALL your decisions. In effect, you trade your time for money (through employment) and consequently your money for goods and services.
Sunk & Prospective Costs
Sunk & prospective costs, interwoven into opportunity costs, play a role in the decision-making process so it’s important to be aware of them and identify how they affect you.
A sunk cost is a cost that has been incurred and can’t be recovered.
- An example of a sunk cost is your college tuition. Whether you graduated or not it’s a cost that has been incurred that you won’t be able to recover. XYZ University won’t give back your tuition no matter how hard you beg.
On the contrary, prospective costs are all future costs that may be incurred or changed if future action is taken.
- An example of a prospective cost is a gym membership. The monthly fee can range from $10 to $50 per month. Often times gyms will also require a non-refundable initiation or activation fee, which becomes a sunk cost upon payment. You have the ability to determine the fate of the FUTURE monthly fees, whether you go to the gym consistently or not, by continuing to pay the fee or cancel your membership.
Be careful that you don’t find yourself in situations where you’re believing the sunk cost fallacy. This fallacy comes into play whenever we continue to invest resources, resulting from a prior sunk cost, for fear that said sunk cost would be a “waste”. This often leads to the hopeless investment of more resources, which can be dangerous.
An example would be waiting in line for 20 minutes and continuing to do so indefinitely because you’d hate for those initial 20 minutes to be for nothing. You may be familiar with some phrases that embody this fallacy: when you’ve passed “The point of no return” or “ Throwing good money after bad.”
Why opportunity cost is relevant to YOU
Determining opportunity costs often forces us to place a value on specifics in our life and that can be an uncomfortable process. If we succeed at the former our battle then becomes evaluating too few alternatives. If we aren’t able to consider enough options the decision-making process becomes very narrow in scope and we leave value on the table.
We must continue to engage the part of our brain consciously responsible for the decision-making, by consistently evaluating all costs involved. This can be especially difficult if you haven’t been conditioned to it. I’ll be honest, I’m still conditioning myself in order to make the best decisions possible.
The real power comes in realizing the alternative(s). The opportunity cost is just a figure until it has comparison and relativity to an alternative. An opportunity cost of $10 doesn’t mean much by itself until I consider what could be done with it instead. When I consider that I could take my wife to get ice cream with that $10 a valuable opportunity has presented itself at that precise moment. Perhaps the most valuable opportunity because it involves one of the most important things to me…my wife, not ice cream.
This concept merely helps identify waste in our lives, whether unnecessary or in excess, so that it may be eliminated. This ensures that we can begin to put our weight behind allocating our resources (time, money, energy, etc.) towards what matters most. Living efficiently, through efficient decisions, can help unlock opportunity and freedom that you never knew existed. Regain and maintain control of your life!
Remember, every decision that you make is telling about what’s important to you because you have chosen one thing over many other options. Choose carefully and thoughtfully.
Words of Caution
I do want to say that orchestrating ALL of your decisions through a lens of opportunity cost is not the way to trek through life. If you did, all of your decisions would be centered around your best interest instead of considering others.
Yes, it is an important concept that I’m encouraging you to utilize; however, there’s a difference between being efficient and being self-serving. I don’t care who you are, healthy relationships are essential in life and you can’t have those with a self-centered lifestyle.
Also, just because you don’t weigh the alternative opportunities doesn’t mean the cost doesn’t exist and furthermore incurred. It definitely still exists, you just weren’t aware or didn’t entertain the option of the alternatives. If you suffer from lack of awareness you’ll need to work extra hard to condition yourself to be aware. Get into a routine of asking yourself questions before making decisions.
- What will I be giving up if I decide to do this?
- How much is my time worth and is this worth my time?
Personal finance is a game that requires reducing mistakes in order to get ahead. Common sense isn’t always the solution for everything. Sometimes there isn’t a clear-cut answer. Mistakes and failures will happen, that is guaranteed. It’s our responsibility to learn from them and prevent them from happening again.
I once had a baseball coach that would often remind us that we needed to “Minimize big innings.” He said it so often, during key moments, that it’s forever seared into my long-term memory.
It’s inevitable that the other team will surely score runs if you make enough errors or a significant one at least. But the team that commits the fewest mistakes and exhibits resiliency is favored to win.
Just like in baseball, mistakes will happen in our lives that affect our personal finances whether we make an irrational decision or an impulse purchase. But we fare a better chance for success if we can reduce the frequency and magnitude of those mistakes all while ensuring we get back up after our follies.
So what are the opportunity costs in your life? Are there ways to optimize areas of your life to get you closer to your dreams? Where can you eliminate waste in order to more fully pursue what’s important to you?