What is “Opportunity Cost?”

Summary

Opportunity cost is the potential benefit lost when choosing one alternative over another, which is not always quantifiable but is ever-present in decision-making.

Abstract

Opportunity cost is a fundamental economic concept that represents the value of the next best alternative foregone when a decision is made. In the context of investments, it is the difference in returns between the chosen investment and the forgone investment. For instance, if an investor chooses real estate over an index fund and the former yields $3,000 while the latter would have yielded$ 3,500, the opportunity cost is $500. This concept extends beyond financial decisions to everyday choices, such as selecting a meal, where the opportunity cost is the satisfaction or utility lost from not choosing the alternative option. Although measuring opportunity cost in non-financial decisions is challenging due to the subjective nature of "utility" or personal satisfaction, recognizing its existence is crucial for understanding that every choice comes with trade-offs in a world with limited resources.

Opinions

The article emphasizes that opportunity cost is not the total potential gain of the forgone option, but rather the difference between what is gained from the chosen option and what could have been gained from the next best alternative.
It suggests that while opportunity cost in financial decisions can be relatively straightforward to calculate, assessing the "benefits" in non-investment choices is more complex and subjective.
The author posits that the concept of opportunity cost is a reminder of the scarcity of resources and the inherent trade-offs in every decision, reinforcing the idea that there is no such thing as a free lunch.
The article implies that although it may be difficult to quantify the opportunity cost of everyday decisions, such as choosing what to eat, acknowledging its existence can lead to more informed and thoughtful decision-making.

Decisions, Decisions

Put simply, opportunity cost is the benefits you miss out on when you choose one alternative over another.

To illustrate let’s consider an example. Let's say you have $10,000 to invest and you are considering two investments: an index fund that tracks the general stock market or a multi-family real estate property.

After you have done all of your due-diligence you decide to invest the $10,000 into the multi-family real estate property rather than the Index Fund. After 1 year the real estate investment has made a return of $3,000 while the index fund had a return of $3,500, what is your opportunity cost?

Some people might be quick to say that your opportunity cost is $3,500 because that is the return you would have gotten if you chose the index fund over the real estate investment. Those people would be wrong.

Remember that opportunity cost is the benefits you miss out on when you choose one alternative over the other. In this case, you do not miss out on the full $3,500. Since the investment you chose had a return of $3,000 your opportunity cost of choosing the real estate investment over the index fund would be $500 ($3,500-$3,000) after one year.

Calculating opportunity cost is quite straightforward in the context of comparing investment options. The “benefits you miss out on by choosing one alternative over the other” is quite easy to see because we can measure it in terms of dollars.

While we cannot always measure opportunity cost, it is a reminder that in a world of finite resources, there is no such thing as a free lunch.

When we attempt to determine the “benefits” of non-investment choices, measuring opportunity cost becomes difficult. For example, what is your opportunity cost of choosing the club sandwich over the Caesar salad at lunch? To be able to answer that we would have to be able to determine what the “benefit” of a club sandwich is compared to the “benefit” of a Caesar salad.

Economists would attempt to answer this by making assumptions about the “utility” (happiness) you get from eating a club sandwich and from eating a caesar salad. Your opportunity cost in this situation would be the enjoyment foregone by choosing the club sandwich over the Caesar salad.

Of course, in reality, it is difficult to accurately measure your “utility” from eating different types of food. That does not mean, there is no opportunity cost when making such decisions, it’s just difficult to quantify. Every decision we make in life has an opportunity cost: By choosing to engage in activity “A” we are foregoing the benefits of activity “B”.

What is “Opportunity Cost?”

No Such Thing As a Free Lunch

Decisions, Decisions

What is an Index Fund?

And Why I Won’t Stop Talking About Them

For an Extended Discussion on Opportunity cost Watch this Video