You may have heard someone say “There is no such thing as a free lunch”. This phrase was commonly said by Milton Friedman, a Nobel Prize winning economist. What Friedman meant is that even if someone else takes you out to lunch, there is still a cost, such as the time and energy you spent in order to be there. You could have used that time to do something else, such as golfing or studying. Whenever people make a decision, they are illustrating the concept of opportunity cost. This concept of opportunity cost enables economists to realize how their choices have consequences and it leads to better decision-making.
What is opportunity cost?
Opportunity cost is the next best alternative to any decision you make. For instance, you might decide to go fishing one day. Instead of going fishing, you could have been going to a movie or studying. However, you enjoy movies better than studying. As a result, your opportunity cost is the movie, not studying, as the opportunity cost is the next best alternative, not the next few alternatives.
How do I calculate opportunity cost?
Opportunity cost is the value of the next best option that is given up when making a decision. Say you were going to either eat a sandwich or eat a burger. If the satisfaction gained from the sandwich is 100 utils, while the satisfaction from the burger is only 80 utils, your opportunity cost while eating the burger would be 80 utils, or the value of the next best alternative.
Opportunity Cost in Real Life
Opportunity cost can help businesses make better decisions. By considering opportunity costs, businesses are able to assess the risks of each options as well as the potential returns. Furthermore, opportunity costs can help individuals see what they are giving up when making decisions. One example of a decision is going to college. If you decide to go to college, the opportunity cost is the four years of income you would have earned if you got a job instead. When deciding whether or not to go to college, you should see if the opportunity cost is worth it. For most people, going to college is better in the long run as their college degree would lead them to have a higher paying job that would make up for the loss of four years of income.
Another real life example is investing in the stock market. The stock market is very volatile so investors have to constantly weigh the opportunity costs of investing in stocks. For instance, let’s say you have $10,000. You could leave that money in a savings account with 5% interest or invest in a stock. If you decide to invest in the stock and the stock returns 7% then you have benefited. However, if the stock returns 1%, then the opportunity cost would be the additional 4% you could have earned if you put your money in the savings account. This is why you have to be careful when investing in stocks and look at the risks and benefits in order to ensure that you will gain a profit from the stock. Opportunity cost is a cornerstone concept of economics, and something that applies to all decisions, whether personal or in the complex business world.
How Opportunity Cost Affects You
Let’s say you wanted to start a business. You can either mow lawns or become a babysitter. Using the concept of opportunity cost, you can calculate and conceptualize what would be most profitable to you based on the price you charge for those jobs. If there is a lower opportunity cost for being a babysitter and you could earn more, then you would do more babysitting jobs than lawn jobs. Visualizing the opportunity costs between two decisions is important and has a real impact on your life.
In a world of scarcity, everything has an opportunity cost since there is always a trade-off involved in all the decisions you make. Instead of reading this article right now, you could’ve been reading, exercising, or learning a new skill. From now on, evaluate the decisions you make and ask yourself if the opportunity cost is worth the decision.