While the last two articles were mostly about spending and saving, I did go hinting about "opportunity cost" and what it means under the context of spending and saving. Just to help you refresh your memory, when talking about spending and saving, the opportunity cost of the amount of money spent is the same amount of money that could have been otherwise saved and employed differently (or vice versa).
Brace yourself as in this article, we will dive deeper into the "opportunity cost", one of the fundamental concepts that must be properly understood if one wishes to climb to the peak of economic study.
And what really is "opportunity cost"?
The fact that economics takes into account of "opportunity cost" is one of the many reasons that distinguishes Economics from other disciplines such as Accounting and Finance. Opportunity cost offers a unique taste to those who thirst for new knowledge. The idea is simple and easy to handle.If you have to decide between option A and option B, choosing A implies that you gave up option B; thus, your opportunity cost would be the B option. Likewise, if you were to choose B instead, your opportunity cost would be the option A. In other words, Opportunity cost is other alternative/opportunity you have to forsake in order to pursue an alternative of your choice. Simply put, it is what we must give up in order to undertake an action.
For instance, by going to your friend's birthday party, you will certainly miss your favorite study time for tomorrow's exam. This might translate into a beautifull red 'F' on your exam paper, a huge loss indeed. For this reason, rational human beings, who are aware that they are not smart enough to review for the exam in 5 minutes while being drunk, usually decide to stay home and study. In this case, not being able to study for your exam is an opportunity cost.
Pick one: Study or Party. Don't try to be this guy.
Note: Just to make things clear, spending on transportation to the party and things like new clothes to get yourself ready for the party are explicit costs, not an opportunity cost. In other words, "explicit cost" is marked as expense in kind or in cash that is easily identified and accounted for, unlike "opportunity cost" which is usually well-hidden behind the curtain and requires you to actually engage in more sophisticated abstract thinking/reasoning to identify it.
But, you might say "If I attend the party, I will be able to expand my personal network...", and based on such reason, even with an exam coming, you might choose to go and dance your night off. In this case, you would still be a perfectly sane being. Why? Because, assuming you are aiming to be an entrepreneur, establishing a solid network with people is very important, and it might be worth failing a test or two! Who to say that you made a bad decision? No one can!
Can we measure opportunity cost?
As different people possess different opinions and employ different approaches in weighing between options, there are many possible outcomes at the end of the decision making process. Thereby, when it comes to determining the exact value of this loss of study time (the opportunity cost of you going to the party), it really is quite subjective, and that is to say, different people perceive this cost differently.
There is a way to (sort of subjectively) quantify the cost of opportunity. One way is to ask yourself how much you are willing to pay to go to the party and how much a lower or fail grade might cost you in the future. The bottom line is that it depends on your personal preference/desire/want/need. Thus, those who put more value into enlarging his network will find attending the party a better option while those who desire high academic distinction will see the staying at home and study option as a more suitable route.
Though subjectiveness is inevitable, economics always leaves space for a more objective and accurate estimate. There are always situations where opportunity cost can be calculated more objectively. In case like buying a new house, for example, you would know exactly that the opportunity cost is the high interest you would have otherwise gained from lending the money to your best friend. So, if the house price is $1 million, and if the interest is 20% on $1 million, then the opportunity cost of buying your new luxurious house is $200,000 that you could have earned had you lent the $1 million to your friend. Ouch!
Opportunity cost and No-Free-Lunch theory
Opportunity cost is also related to the "No Free Lunch Theory". It means that no matter how free (if that makes any sense at all) something seems to be at first sight, do not be deceived; it is not. Even if the party is free to attend, even if transportation is taken care of by the host, you do have your study time to lose (your opportunity cost). Another example about opportunity cost, that can be used to show you that everything is not free, is scholarship (that is to say free study, be it local or abroad). You might think that everything is taken care of by your sponsor who might be your own government or some foundations. But, but, the reality is that it does cost you your next best alternative. This means that even though you don't have to pay a cent, the time you spend studying could be used to do something else, which can be something like opening up your own business or working at the company you love. There is no way of telling which is a better option. Had you decided to run your own business, you might have landed a great deal that earned you millions of dollars later or you might have failed miserably. Who knows? All we know is that your opportunity cost is the time used up on studying that could have been employed differently, be it running a business or travelling the world.
Opportunity cost and the perception of risk
In addition, opportunity cost is direclty connected to the perception of risk. While it does not add to the actual risk you take in pursuing something, it adds to the cost side of the equation, making you more risk-averse. Think about it this way. As an aspiring entrepreneur, joining the party to expand your personal network seems to bear no risk, but when it costs you your precious study time (thus, increasing the likelihood of failing the upcoming exam), your whole perception of attending such party changes. Without any exam tomorrow, you would only expect a certain degree of return, with very little loss like waking up with a headache the next morning, etc,. But, having an exam tomorrow is a deterrence, an opportunity cost that makes you reluctant to go to the party. Why? Because there is a level of uncertainty about whether or not you can make good network, which leads to the question "is it worth going? is it worth failing an exam for?". So, depending on how risk-averse you are, your decision might vary.
Of course, just to make it clear to you, spending your time studying also imposes an opportunity cost which is, you guess it, the loss of opportunity to have fun and expand your personal network. It's up to you to decide! I recommend studying though!
Opportunity cost and its impact at policy level
Opportunity cost can change people's behavior on spending and saving. Policies such as monetary policy which is used to change the rate of interest can be regarded as a policy that alters the opportunity cost people have to confront. At a broader economic scale, the rise in interest rate, for instance, can create more saving for the economy for the reason that it alters people's perception on spending. Think about it. If interest rate was 1% before, $100 spent only means that you have incurred $1 of opportunity cost. Why? Because you could have deposit the money in a bank and earn that amount of interest. However, say, if the interest rate suddenly rises to %10, spending $100 now, by the same logic, means that you are also losing $10. This is a huge difference, especially when spending amounts to hundreds of thousands or even millions of dollar, and that is why this type of monetary policy (one that adjusts the level interest rate) could drastically change the economic landscape of a country, either positively or negatively, depending on the initial setting the country was in.
Moreover, if the economy is that of a sizeable one, like Japan, such policy can even affect its neighbors and distant nations. How? Think of it this way. Japan decreasing its interest rate can lower the opportunity cost of spending and borrowing alike. This means with lower interest rate, the Japanese now finds it less attractive to keep their money in their banks' saving accounts, and this increases their spending and borrowing. As a result, the aggregate demand in Japan will rise. What is the implication? If Japan imports a lot from Thailand, for instance, then the imported products might also experience growth in sales, and thus, increasing the profitability of Thai producers. Well, think of this example as a teaser. We will talk more about this as we venture further in our later articles.
From now on, start factoring in opportunity cost when making decision!
For now, remember, it is necessary to know what you are getting yourself into, meaning always considering the possibility of the existence of opportunity cost. When applying this to your decision in life, imagine a following scenario.
While a business opportunity might look profitable, the profitability might be mediocre at best in comparison to working at a fast-food restaurant. It is extremely important to understand the simple concept of "opportunity cost" because you will need to include it in your major (and minor too) life decisions. For instance, that business idea of yours happens to be starting up a new restaurant called McNoodle. Well, let's just say the daily profit is great. Deducting all the explicit cost, and you have about $50 profit per day. Looking good here, until you decide to grab a calculator and put in your opportunity cost. In this case, it can be your own personal labour cost! Assuming you can work for McDonald at $10/hour, so if you work 8 hours a day, then you would get 80$ daily. Woah! So it turns out you gain more from working at McDonald than the $50 you earn from managing your own McNoodle. That's right, you are actually losing money when incorporating opportunity cost into the equation. I guess that is one of the reasons why we don't see McNoodle anywhere. (lol)
Of course, in the long run, things can be different; you business might grow. For the sake of brevity though, let's leave this for future discussion.
So, opportunity cost should, no, must always be considered. Do not leave it out. A once seemingly lucrative business idea might turn into a less profitable one if you add opportunity cost in your number crunching. So my advice is:
"Don't be silly, think wisely, act carefully because the opportunity cost will be thee's enemy, cookies"