What is Opportunity Cost?

Opportunity cost is one of the most important core concepts in economics and financial decision-making. It represents the potential benefits that are given up when choosing between alternative options for investing resources. Correctly incorporating opportunity costs into analysis can lead to better financial and personal outcomes.

This in-depth guide will provide a full overview of what opportunity costs are, why they matter so much, and how to accurately account for them in a range of financial and life situations.

What is Opportunity Cost?

Opportunity cost measures the value of what must be given up when making a decision. It represents the most valuable alternative that was not chosen.

For example, if you have $10,000 to invest and are considering stocks or bonds, the opportunity cost of choosing stocks is the return you could have earned investing in bonds. Essentially, opportunity costs are the benefits you miss out on by selecting one option over another.

Some key attributes of opportunity costs include:

• They measure the trade-off when choices are made.
• They represent the single best alternative not selected.
• They focus on what is given up, not what is gained.
• They are future-focused since they deal with benefits that could occur.
• They are subjective and not always quantifiable.
• They guide choices when options compete for limited resources.

Put simply, opportunity costs are the value of the next best thing that you passed up. They highlight potential benefits that were forfeited in the pursuit of another option.

Why Opportunity Cost Matters

Opportunity cost analysis is critical because of one simple truth – resources are limited but wants are unlimited. Families, businesses, governments and individuals all must allocate finite money, time, assets, and attention across a range of possible uses. Since not everything can be pursued, it’s essential to account for opportunity costs to ensure resources go where they generate the most value.

Some reasons why correctly measuring opportunity costs is so important include:

• Maximizes gain from limited resources like time and money.
• Forces evaluation of trade-offs required for different options.
• Provides perspective on what is being given up for a chosen path.
• Allows comparison of one option’s benefits to the next best alternative.
• Frames both costs and benefits together for balanced analysis.
• Drives optimal asset allocation across investment choices.
• Improves prioritization when time and resources are constrained.
• Reduces the chance of missteps due to undervaluing what is forfeited.
• Helps overcome biases that focus only on obvious monetary costs.

Overall, factoring opportunity costs into any important decision provides a clearer picture of the trade-offs involved. It ultimately leads to better choices and resource allocation.

READ ALSO: What is Financial Leverage?

How to Calculate and Apply Opportunity Cost

Opportunity cost measurement involves three key steps:

1. Identify Alternatives: The first step is laying out the possible options for how to use resources. List out all viable alternatives for how capital, effort, or assets could be deployed.

2. Determine Value of Next Best Alternative: Rank the options and determine which one represents the next best use aside from the one chosen. Quantify its benefits as accurately as possible.

3. Factor into Decision Analysis: Incorporate the value of the opportunity cost into weighing the overall costs/benefits of the chosen option vs. alternatives. Make decisions accordingly.

Quantifying opportunity costs as monetary amounts is ideal, but not always possible. Even subjective opportunity cost estimates can improve decisions when trade-offs are recognized.

Let’s look at some examples of calculating and using opportunity costs:

• Buying a House – The down payment for a home could instead be invested and generate a 6% return. This potential earnings on an alternative use of capital represents the opportunity cost of making the down payment.
• Attending College – The wages given up by attending school full-time rather than working is the main opportunity cost of choosing a college education.
• Starting a Business – The safe bond interest income one could earn on the startup capital represents the opportunity cost risked by investing in an uncertain new venture.
• Donating to Charity – The opportunity cost of a donation is the alternative goods or services that the money could have purchased instead.

In each case, clearly measuring the opportunity cost creates a perspective on what is being sacrificed in the pursuit of the chosen path. It brings often-overlooked trade-offs into sharper focus.

Reasons People Overlook Opportunity Costs

Despite their importance, opportunity costs are often ignored in decision-making. Here are some key explanations why accurately accounting for opportunity costs proves challenging:

Sunk Cost Bias

People tend to focus on past investments of time or money already made, even though sunk costs should be ignored when looking forward. However, opportunity costs still remain relevant.

Overconfidence

Overoptimism in a preferred option may lead to downplaying potential alternatives. Opportunity costs highlight what is given up in exchange.

Loss Aversion

People prefer avoiding perceived losses rather than acquiring equivalent gains. However, opportunity costs are as much a lost benefit as an explicit cost.

Out of Sight, Out of Mind

Since opportunity costs represent forgone abstract alternatives, they are less visible than concrete monetary costs. But easier visibility does not equate to greater importance.

Focus on Explicit Expenses

Decisions tend to prioritize accounting costs that directly impact budgets while ignoring real implicit costs. Opportunity costs may not show up on financial statements despite their economic impact.

Present Bias

Immediate effects disproportionately impact choices more than delayed effects since the future is discounted. Opportunity costs may accrue in the future so are undervalued.

Simplified Decision Making

Rapid decision-making focuses only on the most obvious pros/cons due to limited time and mental bandwidth. More complex opportunity costs get excluded from abbreviated analysis.

Special Interest Biases

When people have a vested interest in a decision, they gravitate to data that supports their position while downplaying contradicting factors like opportunity costs.

Unsure How to Quantify

Since opportunity costs deal with unknown alternative realities, they can be challenging to accurately measure in dollars and cents terms. But estimates still provide value.

Any combination of these cognitive biases can contribute to opportunity costs being improperly accounted for in all types of financial, career, investment, relationship, health and personal decisions. Being aware of them is the first step toward overcoming them.

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Common Types of Opportunity Costs

While each decision’s opportunity costs are unique, some of the most frequent types of opportunity costs include:

Personal & Leisure Time

• Value of career advancement given up for more leisure time off work.
• Earnings forgone by choosing hobbies over additional paid work.
• Lost potential relationship time from prioritizing solitary pursuits.

Work & Education

• Higher pay passed up by not pursuing further schooling and credentials.
• More rewarding or purposeful job opportunities that required different education/skills.
• Delayed earnings during extended education rather than working immediately.

Investments

• Other asset returns were not earned because capital was deployed to a different investment.
• Value was lost by holding cash and bonds when higher-returning assets like stocks were an option.
• Lower dividends are passed up by selling an appreciated stock rather than holding it.

Real Estate

• Rental income is given up from choosing to live in a home rather than renting it out.
• Returns from selling a property at the peak price rather than later.
• Lower earnings on capital if a larger down payment is made versus investing the cash.

Relationships

• Less time focused on family and friends when career obligations have priority.
• Energy and effort removed from current relationships to start dating someone new.
• Higher income if staying single rather than leaving work early to care for children.

Health & Wellness

• Income potential reduced from choosing lower paying but lower stress jobs.
• Health improvements and lowered future costs if exercising versus other leisure activities.
• Increased energy, focus and productivity from improving diet and sleep habits.

Consumer Spending

• Future savings given up by spending now on non-essential purchases for short term enjoyment.
• Additional goods/services that could have been purchased if buying a lower cost alternative item.
• Improved financial stability from choosing more modest living standards.

As these examples show, nearly every decision carries opportunity costs in the form of benefits we relinquish. Accurately quantifying them provides greater insight into the trade-offs involved in all types of situations and competing priorities.

How to Overcome Biases Against Opportunity Costs

Since opportunity costs are often overlooked, purposefully focusing your decision making process to overcome common biases is critical:

• Question Assumptions – Scrutinize the projected benefits and risks of a preferred choice to uncover rosy assumptions that downplay trade-offs.
• Broaden Perspectives – Seek input from diverse sources to identify alternative options and opinions you may be ignoring.
• Conduct Pre-Mortems – Imagine your chosen option fails and the contributing factors. Were overlooked opportunity costs responsible?
• Reframe as Potential Gains – View opportunity costs not as losses but as benefits you could actively work to capture.
• Visualize Future Regret – Envision regret you may feel years later by not weighing opportunity costs appropriately today. How might your choice change?
• Maintain Balanced Analysis – Require justifying not just the pros of your selection but also the cons of the alternatives passed up.
• Set Reminders to Reevaluate – Schedule periodic reviews of past decisions to assess if opportunity costs were properly considered.

Making opportunity cost analysis a standard part of any assessment process is key. The more experience you gain consciously evaluating trade-offs, the more instinctive it will become to consider opportunity costs.

Opportunity Cost Considerations in Major Financial Situations

Weighing opportunity costs deserves particularly careful attention in certain important financial and life scenarios when stakes are higher. Some examples include:

Leaving Employment for Entrepreneurship

• Weigh reliable salary, benefits, and job security being forfeited. Model cash flow expectations for new business.

Funding Higher Education

• Estimate lost wages giving up work to attend school. Weigh future expected income boost against costs.

Buying a House

• Factor in other uses for a 20% downpayment plus closing costs that will be unavailable. Compare rental costs.

Making Large Investments

• Require quantifying other asset returns being passed up to invest in something new.

Starting or Expanding a Family

• Consider career impacts of reduced work hours and higher living costs. Value of alternative personal goals displaced.

Moving for a Relationship

• Evaluate job opportunities, cultural fit, and friend networks being left behind. Weigh against relationship benefits.

Changing Careers

• Lost seniority and delayed retirement savings by switching fields must be balanced against the potential upside.

Opportunity costs fundamentally shape the overall cost/benefit trade-off in major life and financial situations. Their proper weighting is crucial to making the best-informed decisions.

READ ALSO: What is a Growth Fund?

Common Opportunity Cost Considerations By Age

Opportunity costs affect people differently across various life stages as priorities and obligations shift:

Younger Adults

• Taking lower paying jobs for greater enjoyment and work-life balance.
• Additional income and advances from working more versus leisure time.
• Delaying earning power through more schooling now to boost income later.

Young Families

• Career time lost being a stay-at-home parent rather than working.
• Family experiences given up from intense focus on career advancement.
• Returns missed by using savings for family needs rather than investing.

Mid/Late Career

• Higher pay at more demanding jobs versus move to lower stress positions.
• Education to change fields compared to saving more in current field.
• Peak earnings years of remaining in workforce versus earlier retirement.

Retirement

• Loss of stable retirement pay and benefits by starting an encore career.
• Pursuing hobbies and travel versus earning supplemental income from work.
• Volunteering and time with family over additional retirement savings.

Elderly

• Missed time with loved ones from maintaining independent household alone.
• Lower wealth transfer to heirs if spending more lavishly on self rather than saving.
• More formal care versus quality time with family as caregivers.

Life stage determines what opportunities take priority and which drift to the background. How you perceive opportunity costs evolves across ages even if all choices require trade-offs.

To Recap

Opportunity cost analysis is essential, yet chronically underapplied in financial choices and life decisions. By understanding what opportunity cost measures, common decision-making biases that affect it, and techniques to properly incorporate it into evaluations, anyone can make better choices and maximize resource use. While never easy, consciously training your mind to identify and value opportunity costs will lead to improved decision making and fewer regrets.

Frequently Asked Questions About Opportunity Cost

How do you calculate opportunity cost on investments?

Take the rate of return you could earn on an alternative investment of similar risk. For example, owning a stock you expect will return 7% rather than bonds yielding 3% has an opportunity cost of the 4% higher return bonds could provide.

When might opportunity cost not matter in a decision?

If you have unlimited resources, there are no trade-offs required so analyzing opportunity cost provides little value. But few truly face no resource constraints in reality when making choices.

Is opportunity cost the same thing as economic cost?

No. Economic costs represent actual cash outflows. Opportunity costs are often hidden and represent the unseen benefits that alternatives could have delivered. But smart decision making should account for both.

Can you have multiple opportunity costs in a given situation?

Yes, any decision likely has multiple options on the table. The opportunity cost focuses on the single best one out of those choices. But listing all viable alternatives is crucial input into determining which one represents the greatest opportunity cost.

How do you know if you valued opportunity cost correctly after making a decision?

The best way is to evaluate decisions retrospectively once their outcomes become clear. If the results fell short of expectations, overlooked opportunity costs likely played a role and should be incorporated better next time.

Do companies need to factor in opportunity costs?

Absolutely. Every budgeting, project selection, and resource allocation a company makes should rigorously account for opportunity costs. Otherwise decisions lead to wasted resources when better options were available but overlooked.

Can opportunity cost measurement ever be completely precise?

Very rarely, since the benefits of the paths not taken are usually estimations rather than certain. But getting to even “close enough” valuations of opportunity cost is far better than ignoring alternative benefits altogether.