The cynic knows the price of everything and the value of nothing.
— Oscar Wilde
Opportunity cost can help you make better decisions because it helps put your decisions in context. Costs and benefits are framed in terms of what is most important to you at the time of the decision.
Every time we make a decision involving mutually exclusive alternatives, we will always be subject to this thing called “opportunity cost“.
Opportunity cost is the cost you pay for choosing one alternative over the others. But this cost isn’t “cost” in the regular sense of the word. It is the benefits of the next-best alternative that you have given up.
I hope you’re still with me here. But even if you’re not, don’t worry. I’ll give more examples below.
The concept of opportunity cost illustrated in under 60 words
You are given a choice between two pieces of fruit: an apple and an orange. You can choose only one. By choosing one, you give up the other. If you choose the apple, your opportunity cost would be the enjoyment of the orange. And if you choose the orange, your opportunity would be the enjoyment of apple.
The concept’s that simple. You give up the enjoyment of the orange when you choose the apple, so you “pay” for the apple by giving up the opportunity to enjoy the orange. So far so good? Good.
Let’s shake things up a bit.
Opportunity cost can be for indirect costs too
The scenario. Say a man, we’ll call him Man A, comes up to you and demands from you a glass of orange juice. If you don’t give in to his demands within the next five minutes, he’ll spill permanent ink all over the shirt you’re wearing, which just so happens to be your favourite. Unfortunately for you, you don’t have any orange juice or oranges on hand.
Suddenly another man, Man B, whom you had once given a banana, comes up to you and serendipitously offers to return the fruity favour. Not knowing what type of fruit you like, he offers you a choice of two fruits, an apple and an orange, from which you can take one. You grab the orange, thank him, and quickly make some orange juice for Man A, saving your favourite shirt from certain doom.
Let’s say that in normal times you would pay $1 for an apple and only $0.80 for an orange. Without Man A, the guy who threatened to spill ink on you, you’d have most definitely gone for the apple because it’d have been a better value. But because you knew of what would happen if you didn’t get the orange juice to Man A in time, you opted for the orange.
Opportunity cost is context-sensitive. You gave up the opportunity for an additional $0.20 in value (the difference between the apple and the orange) for the opportunity to save your shirt. Very smart.
Money isn’t everything: Applying opportunity costs to decisions not involving money
Thinking about the opportunity costs also helps us to think about value beyond price (as illustrated by the example above). And sometimes when price isn’t a factor at all, this can be especially important.
The scenario. Imagine facing the decision of painting a wall in your room green or blue. The paint of both colors cost the same, and both look equally good. So you consider flipping a coin and letting chance determine the colour.
But because you’ve learned about opportunity cost, you ask yourself, If I paint my wall blue, what do I give up? And if I paint my wall green, what do I give up?
After giving it a little think, you realise that by painting your wall blue, you’d probably not be able to hang your favourite poster because the colours wouldn’t match. Some of the furniture you had previously picked out would also have to be given up because they didn’t match the blue colour scheme either.
A green wall, on the other hand, would suit the poster and the furniture you picked out just fine. With your knowledge of what you had to give up if you chose the blue paint, you decide to go for the green.
Remember, if cost was the only consideration, you might not have gone for green. If colour preference was the only other consideration, you still might not have gone for green either. It was only after you considered everything in context, figuring out what had to be sacrificed (the poster and the furniture you had picked out), that you could make an informed decision.
Score one for opportunity cost.
Opportunity cost and time
Opportunity cost can also be applicable to time. If you’re stuck doing activity A, chances are you won’t be able to do activity B at the same time.
The scenario. Suppose you’ve just learned how to do your taxes. You estimate that it will take up about two hours of your time if you did it yourself.
Your cousin, who happens to love doing taxes, offers to do it for you for $50, with a free tub of ice-cream (she’s dropping by the supermarket and there’s a two-for-one special).
If you rejected your cousin’s offer, you’d save yourself $50. But it’d cost you two hours of your time doing whatever you wanted, the actual work of doing your taxes, and a tub of ice-cream.
If you took your cousin’s offer, apart from getting your taxes done for you, you’d a free tub of ice-cream. Of course, you’d have to pay her $50 — that’s the cost.
Depending on how much you valued your time, and how much you valued money, I’d say it’s a tough call. If you felt that an hour of your time was worth only a dollar (and two hours of your time being worth two dollars), it would probably make sense for you to do your taxes if you felt neutral about it (i.e. you didn’t hate doing it).
If you felt that an hour of your time was worth $50 on the other hand, letting your cousin do your taxes would probably make pretty good sense, since you’d essentially be getting back $100 worth of time for an expense of $50.
But we’re cold rational beings, and “feelings” of how much our time is worth just doesn’t cut it. So how do we find out how much our time is really worth? Again, here comes opportunity cost to the rescue.
Using opportunity cost to find the monetary value of your time
The scenario. Suppose you earn on average $25 per hour doing freelance work. Let’s say you’ve got more than enough jobs to go around, and that any free time you have could be used to your work. If you didn’t have to do your taxes, you’d be working on your freelance gigs, earning $25 per hour.
The estimated monetary value of an hour of your time would then be $25, which is the amount you’d earn if you had put that hour to work.
So, carrying on from the previous example, if you had given up your cousin’s offer you’d save yourself $50 but be giving up $50 in lost paid work (that’s $25 x 2 hours) and a tub of ice-cream. If you do the math that’s a negative return.
But if you took up your cousin’s offer, assuming you used those two hours you saved to work, you’d break-even and get a free tub of ice-cream.
Everything else being equal, there’s no reason why you shouldn’t be taking up your cousin’s offer.
Think about all your decisions using opportunity costs. And before making a decision, ask yourself these questions:
- If I choose alternative A instead of alternative B, what am I giving up?
- Now that I know what I’m giving up, what are the consequences of giving that up?
- Are there any hidden benefits or costs I’m not seeing? Anything in terms of:
- Money; or perhaps
With practice, thinking in terms of opportunity costs and benefits forgone or sacrificed will come naturally to you. And you’ll start looking not at the price of things, but the value of everything.