Think Opportunity CostsMar 31, 2022
During my college years, I spent a summer in England as an engineering intern for an international company. I was paid a small stipend and, with meager savings, I lived on a shoestring. I watched my expenses and largely lived off bread and pasta. I stayed with a family and they volunteered to bundle milk with my rent until my milk consumption exceeded their expectations. I was capped at one glass a day. It was a fantastic summer but nearly every decision was based exclusively on cost.
Many of us have had life stages where cost was the primary driver for our decision making. This approach can be simple as energy need not be spent evaluating a wide range of options. However, with resources come options and always choosing the low-cost option can have downsides. Often, it is best to think not in terms of absolute cost but opportunity cost.
What Are Opportunity Costs?
According to Wikipedia, the opportunity cost of a particular activity option is the loss of value or benefit that would be incurred (the cost) by engaging in that activity, relative to engaging in an alternative activity offering a higher return in value or benefit. In short, it’s the cost of not choosing the best of available paths. This can be hard stuff – economists can earn PhDs unpacking the nuances of this theory – but it’s worth understanding.
Opportunity costs can be counter-intuitive and significant. While you receive a bill for the real costs in life, for example from your energy provider, you never receive a bill for an opportunity cost. Yet, if you were, you might be shocked at the size of such a bill. For example, some homeowners may save thousands of dollars by moving to solar energy. In such cases, homeowners who choose to not switch to solar are never billed for the opportunity cost of their non-decision.
Writer and blogger, Tim Urban, alludes to the power of opportunity costs in his New York Times essay, “How Covid Stole Our Time and How We Can Get It Back.” He makes the point that, in theory, we have an infinite number of opportunities to direct our life path. We have far more life paths available to us than the ones we are able to choose. But, just because we choose one path, it doesn’t mean that there aren’t options for redirection and change. In other words, our future life path is not set by the past, particularly if we have resources and the courage to take a different course. The opportunity cost can be significant if we have the option to choose a better path in life and decide against it.
Your Past Doesn't Necessarily Define Your Future Path (Source: Tim Urban)
Place and Opportunity Costs
Choosing where to live has an important relationship to opportunity cost thinking. Because where we live matters so significantly in our overall well-being, there is a lot of value in choosing the right place to live for each chapter in life. One of the first steps is to assess whether you are in the right place (the online Right Place, Right Place Assessment is a good starting point). It is important to not just assess place in terms of financial costs but also its impact on purpose, social connection, physical well-being and more.
In some cases, for those that are in a great place for their stage in life, there is no opportunity cost. There is no clear alternative path that offers a better outcome. However, in most cases, there is at least an argument that there is potentially a better place to enhance the odds of thriving. This is one of the reasons why regularly evaluating – perhaps on an annual basis – whether your current place is really the best place for you now and in the near future is important. The decision to not explore this possibility could be costly though you may never get a bill to show you how significant the cost might be. Also, the greatest benefits of a change are likely in the form of quality of life or health which is difficult to ascribe a dollar value to but is real.
Should I Buy or Rent? Think Opportunity Costs
An Example: Opportunity Cost Thinking in Buying vs. Renting
Opportunity cost thinking is also important when evaluating to buy or rent a home. An overlooked dimension of ownership is the opportunity cost associated with home equity. Particularly in markets with limited house appreciation, dollars tied into a house are likely receiving a substandard return relative to investments in the broader investment market. For example, if someone has home equity of $300,000 in a stagnate housing market and the stock market yields a 7% return, this is an annual opportunity cost to the house owner of more than $20,000. This cost is hard to remember because there is no bill associated with it. Such is the reality with opportunity costs.
I am proud of my frugal ways during college. However, I’ve learned that frugality has its limits. Opportunity costs has its limits, too. For smaller decisions, like which checkout line to get into at the grocery store, it’s probably not worth the effort of carefully evaluating which line is the best. However, for the big decisions and for those with resources to have options, it is wise to cast aside decisions based solely on low costs and think carefully and deeply about opportunity costs. It may make all the difference for optimizing the odds of living a long, healthy and financially secure life.
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