Table of Contents
Do economists think strawberry smoothies are a good idea? Instead, it depends on how good the Kiwi flavor is—plus other options. Which introduces the notion of opportunity cost.
Where does opportunity cost come from in everyday life?
In a recent Page One Economics: Money and Missed Opportunities article, Andrea Caceres-Santamaria, senior economic education specialist at the St. Louis Fed, explains opportunity cost as “the value of the next-best alternative when a decision is made.”.
definition of opportunity cost in economics
Everything in life isn’t possible. This is where scarcity comes into play. Despite our unlimited wants, we are restricted in the way we can obtain goods, services, money, time, and opportunities. The concept is what drives choice-and, by extension, costs and tradeoffs, Caceres-Santamaria says.
definition of opportunity cost in economics 1
For example, she gives the example of deciding to buy a $7 smoothie at the mall. In her view, most people would view the choice as one that simply boils down to whether or not you want the drink.
She suggests wearing “a unique pair of economist glasses” instead, to look at the decision from a different perspective, asking:
- How much do I value this?
- What am I giving up now to have this?
- What am I giving up in the future to have this now?
Costs That Are Seen and Unseen
Although we tend to focus on immediate financial trade-offs, trade-offs can also affect personal and professional well-being in the short- and long-term.
Caceres-Santamaria reminds us that we need to consider not just explicit alternatives in decision-making – choices and costs – but also implicit alternatives, meaning “unseen” opportunity costs.
Her goal is to be able to think beyond the present situation and to evaluate other use of the money-that is, not be shortsighted.
Are there any other examples of opportunity cost?
- An exam student spends $20 and three hours at the movies the night before an exam. The opportunity cost is the amount of time spent studying and the money spent on other activities.
- A farmer chooses to plant wheat, but the opportunity cost is planting a different crop, or using the resources (land and farm equipment) in a different way.
- People take the train instead of driving to work.ng. It takes 70 minutes on the train and 40 minutes on the road. The time that could have been spent elsewhere is lost each day.
Is Opportunity Cost a Big Deal?
Some might not consider lost study time or spending $7 on a smoothie as costly decisions, but what about bigger ones — like buying a more expensive home versus a starter home, or spending $1,500 more on an upgraded trim package for your next car?
As Aceres-Santamaria explains, opportunity costs are neglected even more when making high-priced purchases. As an example, a consumer might consider the $1,500 upgrade to the base car price of $18,500 as a relative value.
Rather than comparing a more expensive vehicle to its fancier configuration, it might be more helpful to consider what else $1,500 can buy.
Why the Rush?
“Most of our money decisionmaking involves immediate or sooner-than-later consumption,” Caceres-Santamaria observes. The excitement of consuming today is worth significantly more than thinking about consuming tomorrow.”
We humans are impatient. We are tempted by the immediacy of a promised benefit, versus a payoff that is years away.
It’s worthwhile to examine the future value of money-a concept that many of us have read about in retirement plan literature or heard from financial advisors.
The Future Value of Money
Example 1: The one-time windfall
Say you got a windfall of $4,000 and you want to use it to go on a vacation. Why not? If you consider the opportunity cost, there’s no loss to you. It’s found money, so you’re not losing anything.
With an average annual interest rate of 3%, compounded monthly, you could earn $5,397 in 10 years by investing in an income-producing product.
Your funds will have grown to $6,270 in five years. Both examples exclude taxes and inflation.
In monetary terms, that’s an added benefit. Additionally, you should think about the experiences that an extra $1,400 or more-the future earnings on your $4,000-would make possible.
Example 2: Small, regular savings over time
This is an example of investing one lump sum over time. You may not consider the opportunity cost of buying items on a daily basis, such as the $4.49 caffè mocha you buy three times a week. By investing $54 each month instead of spending it, how much money would you have?
In 10 years, if you dropped the coffee (carefully! ), invested $54 per month and earned 3% compounded monthly, you’d have $7,619 to dip your doughnut into.
Is it too long to give up that regular mocha? By reducing the time frame by half, you will still save $3,554. (Again, these amounts do not include the impact of inflation or taxes.)
Especially when you consider that spending $4.49 on a caffè mocha habit over time dwarfs spending $4,000 on a vacation.
Are you interested in testing your own opportunity cost what-ifs? Whenever possible, Aceres-Santamaria urges consumers to avoid “autopilot” mode when making financial decisions. You can start small – even with a pack of gum – and think of as many different uses for your money as you can.
Read more on the Boo Money
