What Is Opportunity Cost?
When you hear the term "opportunity cost," you are hearing a fancy word for "trade-off." Every time you make a choice, there is a trade-off to consider. You must analyze what you are gaining as well as what you may be giving up.
The most basic definition of opportunity cost is the price of the next best thing you could have done had you not made your first choice. Opportunity costs include both explicit and implicit costs.
Explicit costs are direct, out-of-pocket payments such as wages, utilities, materials, or rent. If you own a restaurant and you add a new item to the menu that requires $30 in labor, ingredients, electricity, and water, your explicit cost is $30. Your opportunity cost is what you could have done with that $30 had you not decided to add the new item to the menu. You could have given that $30 to charity, spent it on clothes for yourself, or added a different menu item.
Implicit costs do not represent a financial payment. Instead, implicit costs concern resources you already own. It's not a direct cost to you, but rather the lost opportunity to generate income through those resources. If you have a second house that you use as a vacation home, for instance, the implicit cost is the rental income you could have generated if you leased it to tenants and collected monthly checks (instead of using it for your own family). It doesn't cost you anything upfront to use the vacation home yourself, but you are giving up the opportunity to generate income from the property.
Although the concept of opportunity cost is heavily rooted in economics and finance, opportunity costs should also include your personal feelings and values. For example, if you love to cook, you shouldn't become a doctor instead of a chef simply because doctors earn more money than chefs. The opportunity cost of becoming a doctor in this scenario would be to deny yourself the opportunity to do what you truly love.
Furthermore, you can drive yourself nuts thinking about all of the things that could have happened if you had made different choices. What if you hadn't gone to the party where you met your spouse? What if you had bought into that financing deal that turned out to be a scam? What if you had gone to Stanford and become best friends with two now-billionaire technology giants? You could go insane trying to figure out all of the things you could have done, so decisiveness is still a virtue.
The goal of studying the concept of opportunity cost is not to make yourself constantly second guess your actions or strategy, but to make sure you are cognizant that your choices do have consequences. Always consider the opportunity cost, but once you've made a decision, have faith in that decision.
Opportunity Cost Is Closely Related to Trade-Offs
If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that nearly every decision requires a trade-off. We live in a finite world—you can't be two places at once. That means if you choose one restaurant tonight, you can't choose another. There are trade-offs involved in that decision, including the relative distance and travel time required to reach the establishment, the price of the menu items at each, the level of service, the type of cuisine, and the speed with which the food is brought to your table.
Even at this moment, you are reading this article when you could have been golfing, writing, exercising, serving at a food bank, or jumping on a plane to a new country. To the extent factors can be controlled, your life is the sum culmination of your past decisions. That, in a nutshell, is the definition of opportunity cost.
On some level, this is common sense stuff that economists like to make difficult. All you have to do is ask yourself:
- What if Walt Disney had never started animating?
- What if Elton John had never composed songs?
- What if Warren Buffett had given up when he was rejected from Harvard Business School?
- What if Thomas Edison had stopped working on the light bulb when he failed the first few thousand times?
- What if Michael Jordan stopped playing basketball when he was cut from his high school team?
- What if Steve Jobs had never returned to Apple to lead its resurgence, fundamentally reshaping the future of technology?
N. Gregory Mankiw. "Principles of Economics, Volume 1," Page 269. Cengage Learning, Inc., 2009.