“Opportunity cost” is an economist’s way of describing a trade-off. In other words, it refers to a situation in which doing one thing comes at the cost of having the opportunity to do the other because limitations mean that you can only pick one option.
That means that while you gain the opportunity to do one thing, you lose out on other options. When you consider the opportunity cost of a particular action, purchase, decision, or investment, it’s important to consider both the explicit and implicit costs.
Keep reading to see how the concept of an opportunity cost is applicable for your personal and financial decisions!
When you consider the explicit expenses associated with a particular opportunity, usually this refers to financial costs incurred. Imagine that you have a few different side hustles, and on a Saturday afternoon you have to decide between spending an afternoon driving for Uber or designing a logo for a client.
If you opt to drive for Uber, in your area you can generally expect to make about $20 per hour. However, Uber typically takes about one-third of your passenger fares (let’s say $6.60) and gas, insurance, and car maintenance represent around $4.80 per hour. So, your explicit costs associated with this opportunity will be around $11.40, meaning your net income from two hours of driving with Uber will be about $17.20 when all is said and done.
On the other hand, if you decide to design a logo for your client, your explicit costs will be lower. Since you already own your equipment and the software you need to design, you’ll only spend $8.00 to rent the coworking space you’ll be working in for the next hour or so. On top of that, you’ll be charging this client $40 for a logo that will take you two hours to complete. When all is said and done, your explicit costs will be $8.00 and you’ll make $32.00 for two hours of design work.
After considering the explicit costs and earnings of your side hustles, imagine that you decide to dedicate more time to your online design business. While this is a wise decision when you compare your possible net income of Uber driving vs. logo design, there’s also an implicit cost associated with this opportunity.
In this case, using your computer for your two free hours on Saturday night to design a logo means that you can’t use your equipment or free time for other side hustles or leisure (the implicit cost). You could, for example, use that time to do specialized translations (net income of $35/hour), take surveys for research companies (net income of $6/hour), or watch Netflix (net income of $0/hour, but helps you relax!).
Opportunity cost in daily life and financial decisions
The concept of opportunity cost also applies to our daily lives and financial decisions. Consider the following examples to see where you might be making decisions about opportunity cost without even realizing it!
When you decide to rent a room in an apartment for $800/month instead of buying a house with a monthly mortgage payment of $500/month, you’re making a decision about an opportunity cost. In this case, perhaps you value the freedom of being able to move easily more than saving $3,600 per year on housing costs.
In most traditional universities, there’s a limit on how many degree programs you can participate in at once. If you opt to study accounting over medicine, you’re making the decision to start one career even though it costs you the opportunity to be able to start another one.
If you decide to buy a $3 coffee on your way to work every day rather than saving that money, you’re making a decision about an opportunity cost.
Consider the math: 260 working days per year x one delicious $3 caramel iced coffee per day x 10 years at the same job = $7,800 spent on coffee (assuming the cost remains the same over time).
The opportunity cost comes in when you consider what else you could have done with those $7,800!
Opportunity cost is also important to consider in investment decisions. Most of us have a finite budget for investing, which means that we should consider our investments carefully.
When making decisions about investments, it’s important to consider your overall budget, time horizons, risk tolerance, and goals, as well as the potential yields and dividends for each investment.
Understanding the concept of an opportunity cost can help us make smarter personal and financial decisions because it helps us to understand that most opportunities imply sacrificing the possibility to do something else.
For more ideas about personal finance and investing, check out the rest of the FlexAcademy library!