One of the great joys of economics is realizing how applicable it is to the world. The lessons of economics don’t only apply to situations where money changes hands. All kinds of human decision-making can be understood through the ideas of economics. In this way, understanding economics can also help us improve our own decision-making and better reach our goals. One tool I’ve found very useful is the idea of opportunity cost.
Opportunity cost is easy to understand. When you have a choice between A and B, and you choose A over B, then the value of B is your opportunity cost, because by choosing A, you give up the opportunity to acquire B.
To give a more specific example, suppose I’m thinking about buying a PlayStation 5 (assume this is a version of me in a parallel universe, who actually has time to spare for video games). There are currently two models of PS5 available – a $500 version that has a built-in disc drive, and a $400 version that has no disc drive. The more expensive version allows you to play games or watch movies via a physical disc or digital download, whereas the less expensive version only facilitates games and movies through digital download. The price of the disc drive version is $100 higher, but that doesn’t really capture what the additional cost is, in the economically relevant sense. If I spend $500 for the version with a disc drive, I can buy just the console, whereas the same $500 could buy me the digital-only version, plus a couple of games to download to the console as well. So if I choose the version with the disc drive I’ll pay a price that’s $100 higher, it didn’t cost me an extra $100, it cost me the games I might have gotten alongside the purchase of the digital version.
(The above example is a bit oversimplified because it tacitly assumes that my next preferred use of $100 after buying the digital console would be buying games, which doesn’t necessarily have to be the case, but we’ll just toss that assumption in for the sake of simplicity.)
Because every decision we make necessarily entails not making some alternate decision, opportunity cost is ubiquitous. And I think there is an important lesson in this that can help people make better and more informed decisions in life, not just about what to buy, but more generally. My advice would be, when you’re making a decision of significance, you should always make the opportunity cost explicit.
When we decide to undertake a new project or set some new goal, it’s all too easy to consider that goal in isolation. But nothing exists without opportunity cost. Setting that new goal will come at the expense of something else you could be doing, or crowding out something else you are doing currently. The easiest way to make this clear is to ask what the “instead of” is, because everything you do is done instead of something else. For example:
- I’m going to take some training courses at night to gain this new certification, instead of keeping up on the latest shows on my streaming service.
- I’m going to go to train to run a Tough Mudder this summer, instead of crossing off more books on my reading list.
- I’m going to volunteer as a coach for the local Little League this season, instead of working on that bathroom remodel I’ve been planning to do.
In my experience, one of the biggest stumbling blocks people run into when pursuing new goals (or New Year’s Resolutions!) is that they don’t make the opportunity cost explicit. They consider the value of the goal in isolation, without thinking about what they will need to give up in order to achieve it. So my advice is to always take a moment to make the opportunity cost explicit before you set out on a new goal. If you can’t find an “instead of” that you’re willing to act on, it’s a good sign that you should reconsider your goal.
READER COMMENTS
Grand Rapids Mike
Apr 4 2023 at 3:57pm
Agree. Opportunity Cost is so important, the idea of specifically considering alternatives is an important part of the process, that can easily be left out. An example in my case is that about 2 years I purchased a new golf driver. The new driver I wanted was on sale, it was a name brand, the reviews were all positive so its seem like the right option, but I did not consider the other options. Anyway since I was hoping to add about 10 yrs or so to my drive and ditch my old 10 yr old driver I bought the new driver. (FYI for those not familiar with golf, each incremental 10 yrs reduce the distance for the second shot, and makes the second shot easier, ie a significant marginal benefit.) Well the opposite happened, the driver didn’t work for me. So now its sits in the basement, maybe I’ll trade it in. So now thinking maybe I should have instead use the funds to get some golf lessons. However since I am essentially a self taught and decent golfer (via golf magazines etc), getting lessons is not my thing. I may have to revisit that opportunity cost option I should have considered.
Dylan
Apr 4 2023 at 6:18pm
This is a good post and I’m generally a fan of looking at things through an opportunity cost lens, however I think this part oversimplifies. Its not something else it is everything else. By taking any action you forgo all others that you could have taken instead. And, when you start thinking that way, decision paralysis is a pretty natural result.
I’ve not yet red Russ Robert’s “Wild Problems” (there’s opportunity cost again!), but my understanding is that the basic hypothesis is that the big decisions one has to make are particularly unsuited for an opportunity cost kind of analysis? You don’t decide to marry your future spouse by looking at what you’re giving up and trying to see if the benefits outweigh the costs?
Kevin Corcoran
Apr 4 2023 at 7:17pm
Hey Dylan –
While it’s true that a decision to take action X necessarily entails not taking all possible non-X actions, this isn’t how opportunity cost is used in economics. Opportunity cost is the difference between what you choose, and whatever your next best option would have been. And the list for “next best option” isn’t quite so massive as that. This is why in competitive markets, economic profit tends to zero – because in those markets your next best option is taken to be about as good as your current option, so your opportunity cost is basically the same as your current choice. If we viewed opportunity cost the way you described, economic profit wouldn’t be zero, it would be negative [really big number].
Jon Murphy
Apr 4 2023 at 8:58pm
No. Kevin has the right of it. Opportunity cost is the highest valued alternative; what you would have done if you had not taken the opportunity.
Dylan
Apr 4 2023 at 11:22pm
That only works if you know what the highest valued alternative is. I’d say, for the big decisions we usually don’t. There’s way too many unknowns.
(This is usually where someone talks about revealed preferences, which I find generally unconvincing in anything other than a tautology kind of way. Just because I sat home and streamed Drag Race all night doesn’t mean that was my highest valued alternative.)
Bringing it back to the practical application, which is what I think Kevin’s post is getting at, I got laid off from my job last week. What’s strange about this is that while technically my options have gone from n to n-1, in that I no longer have the option of staying in my old position, it feels like I now have an infinite number of alternatives and, personally, I don’t find I have a good metric to rank them from most to least preferred. I could try and get a different job with the same employer, I could try to get a similar job with a different employer, I could go back to doing something I previously did, I could work on my own as a consultant, I could start a brand new business, I could choose to not work at all. Those are all good options! In a perfect world I’d do all of them. When I look at any one of those options, I’m not comparing them to some hypothetical highest valued alternative, I’m comparing them to all of them (maybe this is why it takes me forever to make a decision?)
Jon Murphy
Apr 5 2023 at 6:43am
It’s not a matter of “works.” It’s a matter of definition. Opportunity cost is defined as the highest valued alternative foregone.
Dylan
Apr 5 2023 at 7:46am
Sure, but my understanding of Kevin’s piece was a more pragmatic suggestion in how opportunity cost analysis can guide decision making.
This might be true, but for it to be put into practice it means a person needs to accurately rank the alternatives, including not just the aspirational but those darn revealed preference ones as well. Let’s say I’m thinking about training for the Tough Mudder, or reading more books, or learning to whittle, or finally getting my printer set up. Those all seem like worthy goals! And, maybe I can prioritize them in a nice orderly list and decide I can only choose one. That doesn’t help when instead of doing any of them I play another hundred rounds of solitaire on the computer. That’s not going to make my top 100 list of things I want to be doing with my time, yet somehow that’s what I’ll end up doing.
Jon Murphy
Apr 5 2023 at 8:32am
That people make mistakes when estimating their alternatives does not alter the point. Regret is a key aspect of economic life. One doesn’t need to be perfect. One needs only to recognize that life is full of tradeoffs, especially so with big decisions. And we should think seriously about the choices we make. That’s Kevin’s point.
Monte
Apr 4 2023 at 8:08pm
Nice write-up, Kevin. Speaking of which, I’ve never been able to understand the psyche of people willing to wait in line for hours (or even days) for something like a burger or a donut (see McDonald’s grand opening in Moscow, or Krispy Kreme “eclipse” donut craze). And Black Friday? Professional line sitters can get paid up to $35/hr to wait in line for those deals.
The opportunity costs here are tremendous! But it’s all a matter of perspective, I guess. As one consumer psychologist put it, satisfaction = perception – expectation. And unlike waiting in a long line at the SSA or DMV, special events like Black Friday, they say, is an experience.
Here’s a clever little instructional video on the opportunity cost of lines.
Procrustes
Apr 5 2023 at 12:49am
I don’t think that any of this talk of opportunity costs and its applicability to the big decisions such as marriage helps in me trying to reframe my beloved’s thinking in the economic way.
In particular, consideration along the following lines “I am going to dragoon my husband into participating in my recycling efforts and the local “buy nothing” group instead of letting him peacefully enjoy his life and instead I will just throw junk away and use currency in the market place for the things I want to consume”
Monte
Apr 5 2023 at 11:39am
Here’s a great example. But standing in line all day for a burger or a donut? This is a foray into utility theory.
Monte
Apr 5 2023 at 5:17pm
I meant to say, “This is a foray into madness that can only be explained by utility theory.”
Grand Rapids Mike
Apr 9 2023 at 9:45am
Another thought on Opportunity Cost. An important part of economics is that it provides a set of analytical tools to help making decisions in our life and work. The study of economics can get buried in philosophy issues, while certainly important, while deemphasizing the importance of the value of the analytical tools it provides. Opportunity Cost as one of these tools that seemed to never received a lot of attention when I first studied econ or should say in the econ classes I took. It seemed it was mentioned and then just put aside. However Opportunity Cost and it first cousin Marginal Analysis are essential econ analytical concepts that should receive a lot of attention. Every important decision we make or how we prioritize, as we know, requires something left out. So just saying, So now thinking instead of spending on a new golf driver, getting some golf lessons should have been more thoroughly evaluated.
Comments are closed.