Opportunity Costs

What are Opportunity Costs?

Opportunity cost is an economic principle. The opportunity cost of an activity is the highest value alternative activity that you could perform with the same resources, and it represents an important portion of the total cost of any activity. They are well understood and utilized in the business world, but strangely are almost unknown to the general public. Basically, opportunity costs are what must be sacrificed in order to buy/make/obtain/etc any given thing. It’s important to keep in mind that EVERY activity and EVERY purchase has an opportunity cost.

Maybe some examples will help illustrate this important concept. A student in college pays more in opportunity costs that he/she does in tuition. The direct cost of going to college is tuition and books, fees, etc. The opportunity cost of going to college is lost wages for full-time employment during those years. Or think about buying a home. The direct cost is the cost of the mortgage and payments in interest. The opportunity cost is the loss of whatever you could have purchased instead of the mortgage.

Opportunity Costs in Action

Let’s consider one of my favorite examples of the impact of opportunity costs. Imagine our friend Bob walks into a car dealership. He has been good and has saved $10,000 for a down payment on a car. The salesman shows him all the latest models with all the hottest features. He finds one he really wants; but it comes with a price tag of $28,000. Ouch. The salesman has a slick deal for him, though. He offers Bob a 9% loan for 60 months with an easy-to-pay $375 monthly payment. Across the lot, Bob spies the used car section. The salesman’s’ smile slips a bit as Bob begins snooping around in that section. Suddenly, Bob finds a great car that he also likes. It is only 3 years older then brand new, and has a meager 30,000 miles on it. It’s price tag reads $10,000. Poor Bob now faces a dilemma; he can buy the shiny new car with the fresh wax job and that great new-car smell, or he can buy the slightly used car that runs great, looks good, and is much cheaper.

What to do? Most Americans at this point buy the new car. They figure that the cost difference is not that much, and that they can afford the monthly payment, so why not?

In order to help Bob make an informed decision, let’s compare the TOTAL COST of each vehicle. The direct cost for the used car is $10,000. The direct cost for the new car is $28,000 + $4,500 interest = $32,500. Now consider the opportunity cost for the new car. What is Bob sacrificing (besides the dollar cost of the car) in order to have the car? For the used car, he is sacrificing a new paint job, a few thousand miles, and the new-car smell. For the new car, he is giving up the interest he could have earned if he had instead kept his money and invested the $375 that would have been his car payment. If Bob were to invest that $375 each month for 5 years at a 12% interest rate, he would have $30,600 in the bank, $8,100 of which would be earned interest. If he buys the new car, he would have $0 in the bank, and a few scratches on the once-perfect paint. So, the total cost for each car breaks down as follows:

Total Cost = Direct Cost + Opportunity Cost

NEW CAR
Total Cost = $32,500 + $8,100 = $40,600

USED CAR
Total Cost = $10,000 + new car smell = ~$10,000

I’ll let you place your own dollar value on the new-car smell.

Think if Bob were to do this for his whole life. Just pay cash for a car and invest his car payment. If he were to save $375 a month then at the end of 30 years he would have saved $135,000 that would have gone to pay for his cars. If he invested the $375 a month in the stock market and earned the historical stock market average return of 12%, then, after 30 years, Bob would be a millionaire from that alone; his savings account would have a balance $1,310,000. That’s $1,175,000 dollars in interest that the money that would have been paid for cars could instead have earned for Bob’s retirement.

That’s a lot of money to lose out on because of a simple $28,000 price tag on a car. The initial price-tag does not show you the true cost and consequences of your financial decisions. This is why businesses always consider opportunity costs when they are considering what to produce or what services to offer. So the next time you are tempted to purchase anything, think about what the alternatives are. Is there a way you could get far more value for your dollar?

Posted on 20 Dec 2007