We make decisions every day that involve opportunity costs. Often in life, our decisions are mutually exclusive, meaning it simply is not possible to have two things at once. When this is the case, there is an opportunity cost of the thing we did not chose. For example, we can either go out to eat pizza or out for a steak. Rarely would we opt for both at the same time. If we choose one thing, then there is an opportunity cost for not taking the other thing. If we chose to go for pizza because we want it more, then this means the opportunity cost of not having steak is lower than it is for pizza. We can equally say that the opportunity cost of not eating pizza is higher than the opportunity cost of not eating steak, so we chose pizza instead (assuming the monetary cost for both are the same). This is equally important when making investment decisions. An investor will need to carefully consider what potential investment return is being sacrificed by choosing to invest in something else. For example, an investor may choose to invest in a growth Exchange Traded Fund (ETF) instead of a dividend paying ETF. Before investing in the growth ETF, however, the investor should carefully consider what is being sacrificed by not investing in the dividend paying ETF. Dividends are a regular flow of cash and contribute to an investment’s total return. If the growth stock doesn’t perform as expected, then the investor would probably have been better off with by investing in the dividend paying investment. Another factor to consider is if the investor has some kind of liability that needs to be paid. If a regular cash flow is required to service a payment obligation, perhaps investing in the growth stock presents too much risk that the obligation will not be met. Considering what is being sacrificed is important before deciding where to put your money. Considering opportunity costs are also important when making business decisions. Companies are also faced with different investment opportunities. For example, big U.S. automotive manufacturers often face the choice of where to open a new plant, at home or abroad for example. Let’s say an auto manufacturer is looking to open a new production plant. If they open a new plant in Texas, this presents one set of benefits. If they open a plant in Mexico, this presents another set of benefits. Whichever location they did not chose involves opportunity costs. Opening the plant in the Texas may mean no import tariffs and lower transportation cost on the assembled autos, but possibly higher labor costs. Opening a plant in Mexico may mean lower labor costs but possibly higher shipping costs. Most business like the auto manufacturer will take these opportunity costs into account when making this investment decision. It is important to remember, however, that opportunity costs are only calculated by looking at the next best alternative, no matter how many other choices there may be and how many factors go into these big business decisions. Dr. Aleksandar (Sasha) Tomic If You Don't Know What It Is, You Might Regret It Last Updated: 5/26/2022 Advertising & Editorial Disclosure Dr. Aleksandar (Sasha) Tomic Have you ever faced an opportunity or choice and said to yourself, "If I don't do this, I'll regret it"? In a situation where you are deciding amongst several options, there's always a benefit you miss out on that's associated with the choice(s) you don't take. This foregone benefit can be thought of as a cost to you related to making your decision and, in the field of Economics, it's referred to as an opportunity cost. The simple definition of opportunity cost is: Opportunity Cost is the benefit foregone related to the alternative choice when a decision is made. In other words, an opportunity cost is the regret you anticipate from not taking another option. For example, if you spend your time studying for an exam, the opportunity cost would be the time you could have spent having fun. This concept acknowledges not just the explicit costs of a choice but also the implicit costs of what you forgo when you make that decision. Opportunity cost provides a framework for decision-making to find the most benefit, particularly for limited resources like time and money. Within the context of investing, opportunity costs are the expected return on the investments you are evaluating. A simple example of opportunity cost in investing is in the bond markets. If you purchase bonds and hold them to maturity, they will provide a rate of return as stated. Pretend you have a bond that pays 5% and another that pays 2%, and you have $1,000 to invest. The expected return is $50 and $20, respectively. In this simple example, we can see that, all else equal, the bond paying $50 is the better choice. We can use this to illustrate how opportunity cost calculations are made.  Where The return on an option is signified as the benefit minus the explicit costs of that option. In the example above, the returns are $50 and $20. For a business, the return would be the profit it makes from selling its products. Using this formula, when the opportunity cost is positive, it means there is an alternative option with a higher potential value than your current option. When the value of this equation is a negative number, there isn't a higher value option. The opportunity costs for these investments are as follows: Scroll for more
The -$30 and $30 are the opportunity costs of buying the other investment. That is, if you went with the 2% rate of return over the 5%, your "cost" or regret would be $30. In the instance where you select the 5% return investment, your "cost" is a negative $30, indicating you would not regret the decision. This simple example helps us see how to calculate opportunity costs using the formula, but using opportunity costs has its challenges. There are a couple of challenges to calculating opportunity costs. One challenge is that different people can value the same choices differently. In other words, they are subjective to individuals and situations. Another challenge is that in evaluating a decision, we may end up miscalculating the benefits. MONEYGEEK EXPERT TIP Opportunity costs for the same choices can differ for different people and in different situations. Opportunity costs can be more difficult to assign numbers to when you're talking about an example like leisure time. Let's say your employer calls and offers you an extra hour of work at your job. You know the forgone benefit of saying no to your employer: it is the wages you won't earn. But what's the benefit of that time off? That might differ depending on what you do with your time, for example:
Thankfully, our brains are able to tell us what we value at the moment as it relates to our day-to-day lives. In the last example, where you have an opportunity to earn an extra hour's worth of pay, we'll often neglect to consider the future value of our opportunities. If we work that extra hour and then invest those earnings in the future, it can grow to be worth much more. There are many examples of the "skip the latte" argument in personal finance. Say you have a $5 latte every day instead of saving that $5. Over 20 years, you're not just missing out on the $36,500 you could have saved (365 days x $5 x 20 years). You're missing out on $61,655, which is the $36,500 you spent plus the investment returns you could have earned from compounding your savings for 20 years with a 5% annual investment return. Have you ever said or heard someone say, "I/we have already spent…" to justify why a choice is made? Maybe you've heard a story of someone going to an outdoor concert to see an act they weren't that into in the pouring rain just because they had bought the ticket? Or a company continuing to spend money on a failing project because it had already spent a considerable amount on it? At some point, these people had a chance to reassess their situation and potentially back out, despite the costs they had already incurred. These already incurred costs are referred to as sunk costs, and they are costs you can't recover regardless of what you do. Opportunity costs are strictly forward-looking and ignore costs you can't recover because they do not represent your benefit. Say that a company has spent $5 million and two years implementing a new software system. They have one more year of work left and another $2.5 million to spend to complete the system. A new technology has come to the market that provides the same benefits. The new technology will take six months to implement and cost $2 million. In this example, the benefit is the same, so the opportunity costs are just the costs: one year for $2.5 million or six months for $2 million. The sunk cost is $5 million and the two years that had already been spent. When the manager of the project starts to argue that the company has already invested $5 million in the technology, they are committing the sunk cost fallacy. MONEYGEEK EXPERT TIP The sunk cost fallacy is sticking to a course of action when other options have a higher return/benefit. Because opportunity costs are forward-looking, to the extent that it's possible, they should include measures of uncertainty. If you're looking at a set of investment opportunities, your decision should factor in the uncertainty of gains or losses, your time horizon to recover and your subjective ability to stomach potential losses. For this reason, it's a best practice in the investment profession to match an individual's investment portfolio to their risk tolerance and time horizon.
Zachary Schaller Assistant Professor of Economics at Colorado State University Samia Islam, Ph.D. Graduate Program Coordinator, Professor, Department of Economics at Boise State University Don Uy-Barreta Professor Scott Deacle Associate Professor of Business and Economics and Department Chair at Ursinus College Dr. Derek Stimel Associate Professor of Teaching Economics at University of California - Davis Peter Zaleski Professor of Economics at Villanova University Danny Ervin Professor of Economics and Finance at Salisbury University Linda M. Hooks Professor of Economics and Head of the Economics Department at Washington and Lee University Benjamin Shiller Assistant Professor of Economics at Brandeis University Brian Jenkins Associate Teaching Professor and Director of Undergraduate Studies in the Department of Economics at the University of California, Irvine Wendy Habegger Lecturer at James M. Hull College of Business at Augusta University Dr. Leo Chan Associate Professor of Finance Economics at Utah Valley University Dr. Aleksandar (Sasha) Tomic Economist and Program Director of Boston College's MS in Applied Economics Program, Associate Dean, Strategy, Innovation, & Technology, Woods College of Advancing Studies, Boston College Sahar Bahmani Professor of Finance at the University of Wisconsin, Parkside Matthews Barnett, CFP®, ChFC®, CLU® Financial Planning Specialist at Wiser Wealth Management, Inc. Josh Stillwagon Associate Professor of Economics at Babson College Jorgen Harris Assistant Professor of Economics at Occidental College Bruce Sacerdote Richard S. Braddock 1963 Professor in Economics at Dartmouth College David Kuenzel Associate Professor of Economics at Wesleyan University Evan W. Osborne, Ph.D. Professor at Wright State University John Korsak Assistant Teaching Professor, University of Massachusetts Lowell, Economics Department Dr. Michael Snipes Associate Professor of Instruction at University of South Florida Tonya Williams Bradford Associate Professor at UCI Paul Merage School of Business, University of California Opportunity cost is the difference in the benefit of a choice you are forgoing compared to the benefit of the choice you are making. You'll recognize opportunity cost as an estimation of how much regret you'll feel for making one choice over another. Opportunity costs are real in the sense that there is always a missed opportunity when you're allocating resources (time, money, etc.). Economists may refer to opportunity costs as the real costs. However, it's important to note that opportunity costs will not be reflected in a bank account or a company's income statement because they only reflect the choices made, not the choices that are not taken. A simple opportunity cost example is choosing between two investment options with a guaranteed return. Suppose they both require the same amount of investment, but one will pay you $50, and the other will pay you $20. The opportunity cost is -$30 for the $50 return, indicating there isn't a cost but rather a net benefit. The opportunity cost for the $20 return is $30, indicating that choosing the $20 return option would mean you're missing out on a higher potential benefit. This is simple when the net benefit or return is known. But determining the net returns of options isn't always clear-cut. For example, how do you choose between an extra hour of leisure time or an extra hour of paid work? Opportunity cost is a framework that helps us understand choices and can be used to help select the best choice in how to use a scarce resource (time, money, etc.). It's a powerful concept that is the basis for several other economics and behavioral economics concepts, such as comparative advantage. In business and investing contexts, opportunity costs are analyzed in a variety of decisions, such as which products to create and portfolio allocation. Yes. The formula for calculating opportunity cost is to compare the net benefit of one choice with the benefit of another option. If the difference between those benefits is zero, then the opportunity cost is zero, meaning you'd get the same benefit from either choice. About the Author Doug Milnes is the head of marketing and communications at MoneyGeek. He has spent more than a decade in corporate finance performing valuations for Duff and Phelps and financial planning and analysis for various companies including OpenTable. He holds a master’s degree in Predictive Analytics (Data Science) from Northwestern University and is a CFA charter holder. Doug geeks out on building financial and predictive models and using data to make informed decisions. |
How can knowing the opportunity cost of buying a product affect people’s economic decisions?
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