The opportunity cost of a late networking event at work is kissing your child good night. The opportunity cost of watching live rugby match is going for a long training run. The opportunity cost of being a hands-on mum for a woman is advancing her career.
This concept is so important because it can be applied to every aspect of your life and encourage you to examine your choices comprehensively. If you want a bit more of A (e.g. status at work), you must give up some of B (e.g. leisure time).
The opportunity cost of a night in is the money you are saving on dinner and drinks out. Suddenly binging on Suits on a sofa looks a bit more sexy, especially if after a while you can treat yourself to cocktails at Dabbous.
The opportunity cost is also a handy concept to apply to your savings and investment decisions.
Say you have received a bonus for all your hard work last year. Let’s say you are only considering two options: pay down some of your mortgage as a lump sum or put money into a savings account. Your mum tells you to pay down your mortgage, but with an economist’s hat on, you should compare the interest rate you are currently paying on your mortgage with the savings rate offered by your bank. Right now interest rates in the UK are low (the base rate is 0.5%), so chances are you are on a good deal paying just 2% interest. Many banks are currently offering saving rates of 3%, so leaving all other factors aside for the moment (e.g. tax implications), you can see that the opportunity cost of paying down some of your mortgage is forfeiting extra 1% interest you could earn on saving cash.
The concept of opportunity cost helps us estimate true economic costs of every decision or venture. If you have a spare room, your opportunity cost of keeping it as an occasional gesture of hospitality to your mum and dad is earning extra income. Conversely, getting a lodger has an opportunity cost of having to share your kitchen and your fridge plus any other inconveniences you may come up with.
Consider a former fund manager starting her own business making chutneys. Let’s assume she made £140,000 in a year selling chutneys and made a profit of £40,000 after taking into account all the costs. However, to estimate her true economic profit, we would also need to take into account the salary she would have made as a fund manager. The salary she decided to forgo is he opportunity cost of running her own business. (Of course, you may argue - correctly so - that running her own business has additional benefits too: greater freedom, doing something meaningful, working on something with a greater economic potential in future. Alternatively, sticking to the concept at hand, the opportunity cost of making chutneys is doing a meaningless job stuck in an office with a bunch of colleagues who bore her to death.)
It’s also important not to mix up opportunity costs with sunk costs I have written about a while back. An opportunity cost of a fancy dress outfit taking up a lot of space in your wardrobe is not £40 you bought it for, but a potential resaleable value on eBay (£4, taking into account all the spilt beer soaked up by the costume, posting costs and the eBay commission).
The economist Tim Harford is fond of using opportunity costs to help him make daily decisions too. His recent article in FT Weekend has been re-published on his blog. He argues:
"However dizzying the idea of opportunity cost may be, it’s something we must wrap our heads around. Will I write a book review? Will I chair a panel discussion on a topic of interest? Will I give a talk to some students? In isolation, these are perfectly reasonable requests. But viewing them in isolation is a mistake: it is only when viewed through the lens of opportunity cost that the stakes become clearer.
Will I write a book review and thus not write a chapter of my own book? Will I give a talk to some students, and therefore not read a bedtime story to my son? Will I participate in the panel discussion instead of having a conversation over dinner with my wife?
The insight here is that every time we say “yes” to a request, we are also saying “no” to anything else we might accomplish with the time. It pays to take a moment to think about what those things might be."
What decisions are at stake for you today? What are the opportunity costs involved?