Understanding Opportunity Costs = Better Decisions

June 17, 2007

Identical twins Amal and Juan graduate with Bachelors degrees and receive the same job offer. Amal passes up the job offer to pursue a Masters degree while Juan takes the job offer and begins working. Two years pass and Amal graduates and begins working. By this time Juan has been promoted to a position that is comparable to Amal’s starting position, and Juan’s salary has increased to an amount that is comparable to Amal’s starting salary. So who made the better decision, Amal or Juan?

Opportunity Cost 101…

In business and in life, every choice we make comes at a cost since we forgo other possible alternatives in the process; this cost — whether it’s money, time, education, health, et cetera — is known as an opportunity cost. More specifically,

An opportunity cost is the value or benefit of the next best alternative.

In the example above, one could argue that Amal made the better decision since a Masters degree would be valuable if both lost their jobs and found themselves in a competitive job market. Yet when you look at the situation in terms of opportunity costs, Amal’s Masters degree came at a cost of two years salary. If Amal and Juan stay on equal career paths from here on out, Juan ends up making the better decision.

Opportunity Cost in the real world…

While the example of Amal and Juan is situational, opportunity costs definitely apply in the real world. Opportunity costs especially come into play when time is of the essence like starting a business, fixing and flipping an investment property, selling your home, et cetera.

In some cases, saving money by doing things yourself can be beneficial. Yet the benefit of saving money has to be weighed against the benefit of getting things done quickly and correctly by a professional. For example, anyone can learn how to build a website or remodel an investment property on their own, yet if doing so comes at a cost of several months of lost revenue or rent, then is it really worth it?

Opportunity costs even come into play in the pursuit of happiness. Take for example the classic situation where a parent wants a child to become a lawyer or doctor. If that child has a strong passion for something other than law or medicine, then giving in to their parents’ wishes may come at an opportunity cost of their happiness. Which would you rather choose, lifelong happiness or a life of misery living out someone else’s dream?

In conclusion…

Opportunity costs are all around us and they differ from individual to individual. Take one look at Steve Jobs and Bill Gates and think of the opportunity costs if they had decided to forgo their entrepreneurial pursuits and continue their college education instead. Had they not been blessed with business acumen, things would be very different now. Ultimately, opportunity costs apply to anything which is of value to a person and being conscious of how they apply to your situation can help in making a satisfactory choice/decision by considering the value or benefit of the next best alternative.

Sincerely,
The Closet Entrepreneur

» This entry was filed under Advice and tagged with: Advice, opportunitycost, startup

6 Comments

Kumar

Just some comments on your summary of opp. cost, I think initial degree would set pretty much the minimum income that is almost guaranteed coming out of school – e.g. engineering 55k. Masters 60k, DPharm 80k, etc. Parents/kids might select a career path, to do a certain degree just so that they know the minimum income they will make out of school is XXk, and they will have a good income throughout their lives. But what this vision of which is the right path does not take account is the success factor, and what is true success – different for different folks.

How successful will the person be once they are on that chosen path? How happy will they become from taking that path and staying with it for a while? What outside forces come into play in that career and lifestyle….i.e. dealing with your peers that are cut throat sales or lawyers, egotistical doctors, night shift compressed work weeks:), etc.. All these factors come into play at anytime during the persons career….and it requires us all to evaluate our happiness….to struggle through and hope the phase ends or becomes better, or take the plunge and switch jobs/careers etc. It might not be opportunity cost, because its not an opportunity that you had, but came to be without you doing anything in your environment. The opportunity cost that you are forced to reckon with is the cost of leaving your position 🙂 .

How successful will someone be is dependent on someones skills, determination, luck, who they know, destiny etc…We can control a few things like education, networking, etc…..which is why every parent will harp on education as its pretty much a given set income. The rest….no one can predict….it just comes to be….and what life has in store for you. I have seen super smart people, Mozarts of society, work their hardest in life and be thrown a lot of cr@p in life their way…they make decent income, but with a lot of struggle, and I have seen people with no education, or minimal, be highly successful in income and in happiness. No real recipe for happiness besides to keep perspective in life, fight all the battles with honor…many you never picked, be sincere in everything you do, and that would allow you to at least have happiness within…and inner peace hopefully 🙂 .

The thing I always ask people is this…if one is on your death bed, and moments before one passes, what will one reflect on? Now how successful one was in those things, thats what one hopes to be successful in. Knowing that before we get to that stage before we pass and making strides to make whatever “that” is be successful….that should be our long term goal and focus…and we should never lose sight of that in all our pursuits.

Just my 2cents of ramble.

K

Jun 17th, 2007
Steve Olson

People have a real hard time with this concept. Even intelligent people. I try to explain it to my neighbor who has a PHD. He works on his own cars. I asked him if the 400 bucks he saves is worth an entire weekend of frustration. What else could you be doing with that educated mind? Are your relationship sufferring? Children? Why not use your intelligence to create something of value?

I know people who will drive an hour across town to save 50 cents on gallon of milk. How much is their time worth?

I told a friend that I paid a guy 8 grand to finish my basement, and he told me I should have done it myself and I got ripped off. To which I replied… No I ripped him off… I enjoyed the last 6 weekends and did the things i wanted to do and he lost his weekends and all he got were several thousand dollars. I can always get more money, but he’ll never get his time back.

Jun 20th, 2007
Frank Fullard

The concept of “opportunity cost” is, in my experience, one that is totally alien to the entrepreneurial mind. The typical entrepreneur pursues opportunity without regard to cost. They are more likely to be driven by the notion of opportunity, not constrained by notion of cost!

Jun 20th, 2007
TOMAS

@Kumar – As with any decision that a person makes, there’s an inherent set of risks/benefits that a person may not be able to account for, these are known as “hidden costs” in the world of opportunity costs. For all we know, Amal could’ve met the future CEO of a Fortune 500 company that would’ve hired him on with a $1M annual salary, yet the opportunity cost of Amal getting his Masters is still a salary loss of two years regardless of the hidden cost/benefit involved.

The example of Amal and Juan is completely situational and I only use it because I’ve actually witnessed something very similar like this happen to friends of mine, yet millions of outcomes exist. Just to reiterate, opportunity cost deals with the costliest benefit lost from making one choice over another and hidden costs/benefits will exist. In the end, opportunity cost comes down to this – are you making the best use of your time, money, energy, equity, intelligence, happiness, et cetera.

@Steve – Great comment, I couldn’t have said it better myself. 🙂

@Frank – I understand what you’ve stated, yet even if an entrepreneur is purely driven by opportunity and is presented with several opportunities, he/she will choose the best opportunity based on the benefits/costs involved.

Jun 22nd, 2007
Evelyn Smith

Dears,

This is not a comment but a question I need help and if possible response sent to my email box.

Here we go:-

The relevants of opportunity cost to the economy (discuss)

Appreciate your comment.

Thanks
Evelyn.

Feb 4th, 2008
TOMAS

@Evelyn: I’m probably the last person who can discuss the relevance of opportunity cost to the economy, but you might want to start by checking out the topic on Wikipedia here. Also, most Macroeconomics 101 textbooks dedicate several pages to opportunity cost, you might want to see if your local library carries any – hope that helps!

Feb 17th, 2008