Everyone makes decisions differently. Some people are impulsive and some people scrutinize a decision to the point of no action. These are extreme cases and somewhere in the middle is a healthy place to be. Opportunity cost is an economic concept that if you’re familiar with it can help anyone make better decisions. There’s a great chance that many of you are already using some aspect of this concept to make decisions. 

First, what is Opportunity cost? Opportunity cost is formally defined as “the cost of any purchase is the next best alternative use of that money, or the forgone opportunity.”  There are two parts to this definition that you need to understand to completely understand this concept.  Let’s first start with “The cost of any purchase is the next best alternative use of that money.” If you have $10 and your first choice is to use that money to buy a coloring book and your second choice is a pair of socks. The pair of socks would be the opportunity cost of the coloring book. We are assuming that both the pair of socks and coloring book are the same cost. The second half of the definition “… or the forgone opportunity.” What are you missing out on if you use the $10 to buy a coloring book? In this case it’s the pair of socks.

Now you understand the basics of opportunity cost by definition how economists, businesses, and policy makers use this concept. A business may be in a position to grow their business and is in the process of deciding which is the best way to do so. They may be faced with the option of building a new factory or extending a current factory, launching a new product line that will require research, development and marketing, and investing in the stock market.

Let’s say this business wanted to build a new factory which is their first choice. They will then compare their first choice with their second choice which could be in this case launching a new product or investing in the stock market. Let’s use the launch of a new product. The company  would first determine how much it would cost to build a new factory and launch a new product. Then they would estimate what benefits they will get from building a new factory and launching a new product line. Let’s say the company decides to go with an increase in revenue (company’s income) as a comparable measurement.

To make this example simple we are making the assumption that the cost of building a new factory and launching a new product line is the same. With that said the company estimated that building a new factory would increase the company’s revenue by $20 million per year while launching a new product line would be $17 million per year. The company’s first choice is building a factory which makes launching a new product line and $17 million the opportunity cost if they decide to build a factory. The money the company uses to build a factory they won’t be able to use that money to launch a new product line and receive the $17 million increase revenue that comes with launching a new product line. The opportunity cost of a decision is what you lose out on if you make one decision. 

To further add to the insight of this example. If the company chooses to launch a new product line as their first choice then building a factory and $20 million in increased revenue would become the opportunity cost of choosing to launch a new product line. You may be thinking why would a company choose to launch a new product line their first decision if they are only getting $17 million in increased revenue versus $20 million. Isn’t that a $3 million loss? Yes but you must think of the company’s goals. Increased revenue is only a measurement and building a new factory may not align with the company’s goals. So they can afford to forgo $3 million if they make that decision. The company may decide to launch a new product line because it helps the company expand its brand to a wider customer base, and increase brand recognition. It may also be a way to stay competitive.

The benefits of understanding opportunity cost is that it gives a better understanding of the cost of a decision. It makes you understand that the cost of a decision is not only a dollar amount it’s also what you are unable to do if you make certain decisions. Understanding this will improve anyone’s decision making skills.

An economist or a policy maker would use the same approach when considering opportunity cost. Most people are not a corporation, an economist, or a policy maker but understanding opportunity cost can benefit them. So how can a regular person benefit from understanding opportunity cost? Examples below will cover scenarios that most people will face in their lifetime.

GRADUATING HIGH SCHOOL

A high school kid a few months away from graduating is faced with a major decision of what to do after graduating. This decision can be daunting for many reasons. One reason is that the number of options can be intimidating. A person graduating from high school may be faced with many options such as should they go to college, start working, join the military, or even take a gap year to travel and find themselves.

For this example let’s say a person about to graduate from high school is deciding between going to college and taking a gap year to travel. What is the opportunity cost if this person chooses to take a gap year and travel? Well, the opportunity cost of taking a gap year is going to college. Going to college is the next best thing from taking the gap year. This person is giving up one year of college education to travel. Everything that person would learn and experience is the opportunity cost of taking a gap year.

Most people are familiar with direct cost and how to arrive at it. In our take a gap year and go to college example the direct cost would be the cost to travel for a year and the cost of going to college. If tuition, books, housing, and meals adds up to $60,000 then that would be the cost of going to college. Similar to the college cost, if plane tickets, housing, food adds up to $20,000 for the year then that is the taking a gap year cost. Once again many people only consider these costs and don’t take into consideration opportunity costs. We make decisions based on the benefits we are expecting to receive. The benefits of going to college may be a job with a certain salary, and the opportunity to network with other students, just to name a few benefits. Taking a gap year to travel may provide certain benefits such as personal growth and development, and the opportunity to network with people around the world. Depending on what benefits a person values the most will determine the choice they make and what they are willing to pay to achieve it. The cost of a decision is its direct cost and opportunity cost.

STARTING A BUSINESS

Here’s another real world example that many people may encounter. Should they start a business or choose another path. We will use the concept of opportunity cost to arrive at a decision. It’s important to understand that the monetary value that something has is not it’s only value. That subject value that we place on an item and an experience plays an important factor when making a decision. From the perspective of an individual not because a choice provides more of a certain benefits doesn’t mean it’s the best choice for an individual. One job may pay over $100,000 per year but due to the added stress a certain person may be more happy with a job that pays $30,000.

If a person is faced with the choice of taking a certain job or starting a business, the opportunity cost of one choice would be the other. If the individual chooses to start a business the opportunity cost of starting a business would be the job that the individual didn’t take. A person who recently completed a study of architecture is faced with the opportunity of starting his own company or taking a job offer that pays $100,000 per year. This person decides to start their own company and these are the reasons.

The opportunity cost of starting an architecture company is what is given up to do so which is the $100,000 job salary. This person chooses to start a company now because their living expenses are low. They are delaying starting a family so their only expense is themselves. They estimated that the average company takes five years to break even then turn a profit. They also estimated that the profits will be enough for them to limit their role in the company and start a family. This person could also choose to take the salary position, save as much money as possible in five years, make connections, and then start their own business. In this case starting a business would be the opportunity cost. It’s important to understand what you value and understand what you are giving to get the things you value. 

FINAL THOUGHT

You don’t have to be an economist, a policy maker, or a business analyst to utilize the concept of opportunity cost. Many of you are already using this concept whether you are aware of it or not. You don’t have to learn any complex formula to calculate cost. You do need to know what you’re giving up in place of making a decision and what is the value of that decision. You also need self awareness so you can better make your choices. If you have the ability to assess the value of what you are giving up in place of what you choose you can decide if a certain decision is worth it or not.