Opportunity Cost Definition: As it Relates to Saving Money
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One concept that I bring up a lot in my articles is opportunity cost. This is something everyone actually has experience with whether they know it or not. I think that in order to maximize your savings and earnings, you should have a firm grasp on opportunity cost, and take its laws into consideration when making decisions.
All of us have some experience with opportunity cost. When a college student looks at a textbook they have to buy for class, and it is $100, some may very well say, “wow, I could get 5 cases of beer with that!" I describe opportunity cost as what you give up by using resources such as time, money and effort to do one thing instead of another. In the case of our college student, they are giving up five cases of beer in order to purchase one text book. In economics they will apply a happiness or satisfaction factor to this exchange, and they will apply a unit of measurement to it, then further define opportunity cost as what your next best choice would have been, or what would have made you the second most satisfied or happy if you did not spend it on your first choice.
As you can see, opportunity cost can be very subjective. If someone asks, “why would you spend $100 on a text book when you could buy 5 cases of beer?" They have a different opportunity cost and view than another person who asks, “Why would you spend $100 on a new text book when you could get a new pair of shoes”?
My goal to help understanding is to first make opportunity cost objective instead of subjective, and then apply it in ways that will save money, and maximize earnings by making smarter decisions.
First I will apply opportunity cost to money, since that is something we can always agree on, and makes the outlook objective. So opportunity cost will be defined as how much you could save if you did not spend it. That way it takes all of our personal preferences out of it and simplifies it to spending versus saving.
As a simple example, say you have already gone grocery shopping and have food in your kitchen to make a lunch to take to work, not costing you any more than you have already spent. Now assume buying a lunch at work would cost you $10. The opportunity cost of buying lunch versus taking it to work is $10. If you took your lunch to work, you could save $10. This is a very straight forward example that all of us can follow.
Here is where opportunity cost can really be applied and understood effectively. You got invited to a sporting event, tickets are free courtesy of your friend and the game is at 1:00. You leave work for the day and attend the sporting event. Since your friend gave you the ticket you pay for parking, a couple beers and nachos, totaling $30. You go home that night and tell your friends how you had a great time at the game and it was only $30 for the whole evening and feel good about how much you spent.
But how much did the game really COST you?
Since you took the afternoon off and earn an hourly wage, you did not get paid for missing the 4 hours of work earning $100 at $25 an hour. Now the game cost you a total of $130, since applying opportunity cost, you gave up earning $100 to then spend $30, which is hitting you twice on the back end. By my definition, the opportunity cost of that day was $130 since you could have saved that $130 instead of spending it or not earning it all together.
So the question about opportunity cost becomes what are you giving up in order to get something? Are you giving up sleep in order to study for a test, are you sacrificing a better retirement to buy an expensive car, are you not going to earn money so you can go spend money?
These questions and this concept resonate with us on a daily basis. We only have so many hours in a day, and can only do one thing at a time, so our choice to do something is the same as saying that we are choosing not to do many other things. The professional athlete gave up the last two years of college and a degree in order to play a professional sport. It is not whether the choice was right or wrong, but the opportunity cost, or what he gave up was a college degree.
The key is to really think about the situations that are magnified by not doing one thing and doing the exact opposite. Such as eating a double cheeseburger instead of going on a run, that hits you harder than simply not eating and not going on a run and say watching a TV show. Or like my example earlier, choosing to go spend money instead of earning money, which multiplies or magnifies the consequence.
It is up to each of us personally to determine our priorities and to make decisions based on what we feel is important. In the world of saving money, some simple examples come to mind.
Will you choose to take out a loan on a car, paying interest on a depreciating asset, essentially multiplying the effect, and not having that money to spend on other things, which is another level of opportunity cost. Or will you buy a less expensive car for cash and save the difference earning interest on it, magnifying it the other way. Essentially turning a lose-lose into a win-win.
You cannot avoid opportunity cost, but much like the WYHTE Phenomenon (see my other articles) you can have it work for you or against you. By understanding how opportunity cost works, and how it is applied, your decisions may be altered in a way that saves you money. Maybe my earlier example of going to the game instead of working would change to seeing if you can go on Saturday, pay $15 for a ticket, and the $30 for everything else, but earn $100 at work, and at the end of the day being ahead $55, since you would not be working on Saturday anyway.
Or maybe our college student finds the text book he needs used for $60, and can buy a case of beer, still being ahead if he were to do both.
We subconsciously make decisions based on past experiences, preferences and many other criteria that factor into opportunity cost, but being proactive about the decisions we make can save us a lot of money, time and effort.
This is a great concept that illustrates how emotional money can be, and how emotion aids in our decisions regarding money. It is easy to see the examples on paper, but when presented with the chance to ditch work and go to the game, it feels so good to get out of the routine and do something you enjoy. This is the game we play every day, and it is up to us to determine how important it is to stick to your goals and when to give yourself a break, because just like anything else, it is important to reward yourself and take a break from the plan if it helps you stay on track over the long run.
There are an endless number of ways to apply opportunity cost, from relationships to cost and time, to effort and price. You can take it as far as you want to achieve the goals you have set. The bottom line is simply understanding how it works, and knowing the underlying implications of a decision can instantly change your perspective and maybe your decision, all saving you money.
Do you have any examples of how you use opportunity cost to make decisions and save money?