What is... | October 10, 2013

What is opportunity cost?

If you had a day off, would you rather play sport, clean the house, relax with family or do something else? The question helps explain the key concept in economics known as “opportunity cost”. Opportunity cost is perhaps best known in relation to investing choices but in fact comes into play many times a day, every time we “lose” a potential gain when an alternative is chosen.

I choose cash (but what am I missing)
A classic example of opportunity cost is the loss of potential earnings from money that is left sitting idle.
The “loss” of potential earnings from money left in a safe includes interest that would be earned if it was in the bank – or gains if it was invested in share, housing or other markets that rose. Here the cost effectively has a monetary value.
However, the “loss” can also include a range of other “gains”, such as joy that would be gained if the money was spent on seeing an enjoyable movie.

Do I take the more expensive hi-fi?
When shopping, there is evidence opportunity cost might be too easily overlooked.
Research titled Opportunity Cost Neglect published in 2009 detailed an experiment involving the choice between hi-fi stereo systems priced at $700 and $1000. It found that people were more inclined to buy the $700 system when the price difference was expressed as the ability to get the cheaper stereo plus $300 of music to play on it. The authors write that “the opportunity cost became obvious” when that alternative was explicitly laid out.
The same notion holds true when comparing any similar products but also when deciding whether to buy in the first place.
A simple way to explicitly lay out opportunity cost of discretionary income is to convert the cost into how much of “something else” you could buy for the same price. For example, comparing whether you prefer a EUR20 trip to the cinema or having friends over for a EUR12 pizza and an EUR8 home movie.

On my day off I want to relax
Similarly, if you’ve decided on the best hi-fi for you and found it $50 cheaper at a store an hour away, the opportunity cost of time comes into play.
The “loss” that occurs by choosing to travel to the store might be joy from playing sport or satisfaction from cleaning the house.
One way to address this is to work out how much you value your spare time (taking into account your income, how much free time you have and other factors) to come up with an “hourly rate”. It might help with decisions around whether to outsource cleaning and other tasks. Likewise, an eZonomics poll explains how deciding whether to take a second job could well come down to more than just a matter of money.

Lessons for savers
Simple steps might also help to apply opportunity cost to saving and investing.
The Opportunity Cost Neglect paper also cites research that finds making alternatives in saving and investing decisions more explicit can also change people’s choices.
There is a tendency to choose an immediate reward when presented with a choice between receiving money now or a noticeably larger sum in the future. However, it says that when the question was specifically worded to explicitly state the alternatives (or the opportunity cost) people were more likely to choose the larger future sum.


eZonomics team
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