Opportunity Cost - From Economics Theory to Life Application
June 5th, 2006 by Matt InglotFirst year micro and macro economics have been one of the most genuinely educational university classes that I’ve taken. I enjoyed them so much that I tutored both courses while I was still taking them. Regardless of whether you are a business, philosophy, or music student, getting this knowledge under your belt is useful for more than just a better understanding of CNN.
One concept I especially enjoy is opportunity cost, which I’d like to explain quickly and then dive into why I love it. I’ve applied it to my business planning, philosophy, and choosing directions in my life with great success.
The Theory
Opportunity cost is just a way of measuring the true cost of something by looking at your next best alternative. Its power comes in not being limited to measuring cost in terms of money, allowing you to take into account significant factors that are difficult to quantify in dollar values. For example if I choose to take a business class as an extra credit for the term, I am foregoing the use of $500 tuition and 6 hours per week that I could use for funding and working on my venture, or broadening my horizons by learning something that isn’t already my main subject. My opportunity cost would be the most valuable way I could have used that time and money (the two things I identified here as being my costs).
The Real World
Like most really useful lessons, opportunity cost seems critically obvious yet isn’t applied often. It’s just a way of approaching a problem or looking at things, so who cares. Well changing the way you think is your greatest key to success, a lesson that Yaro Starak and Pamela Slim both hit on today (Mondays are great days for blogs).
Allowing myself to think in terms of opportunity cost has made it possible to gain perspective and sanity over some tough decisions. Thanks to the next best alternative idea, it’s possible to view a choice based on its cost in relation to the benefits of the other choice rather than attempting a pros/cons approach that separates benefits from cost (and requires looking at four sets of points). Let’s see why this works.
I write about entrepreneurship often as it’s my passion and this is an entrepreneurship blog. So let’s take the example of Bob starting a new business vs working a reasonably interesting job.
By starting a business Bob will forego:
- $50 000 per year salary ($700 000 in ten years, taking raises into account)
- Purchasing a cottage anytime soon (the money he saved for the cottage will go towards the business)
- Traveling around the world on business
- Not working after 5pm and enjoying lazy weekends
- Low risk of retiring poor
- …
By choosing the job Bob will forgo:
- Ownership of a business projected to be worth $1 million by year 10
- $25 000 per year salary for the first five years (based on projected earnings and re-investing non-essential money into the business)
- Turning his woodworking hobby into a way of life as he’s always wanted to
- The only realistic chance of owning a Ferrari (Bob’s dream car)
- Early retirement
- …
Based on Bob’s priorities and philosophy on life some of the above costs will seem much greater. I find that when major decisions are put in this form I can immediately perceive a difference in cost, even if I can’t quantify it all in dollars. Since each decision is framed in terms of forgoing the other’s benefits, the perceived lower cost decision is automatically the right one (at least if you’ve identified all the major factors).
This same process can be applied for anything from choosing a university program to deciding how to best spend the morning. In theory you could apply it to everything, but I prefer to use it as yet another tool and to apply opportunity cost where I find doing so is natural.
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