Opportunity Costs

A short while ago, I posted about the sunk cost fallacy… that ugly inclination of ours to “throw good money after bad”. I became aware of the concept of sunk costs as I took a class on basic economics. I’ve noticed that learning about sunk costs has helped me recognize them in my life (and avoid souring the experience further).

I’ve likewise benefited from the similar concept of opportunity costs. Opportunity costs are like the cool older brother to sunk costs. A knowledge of opportunity costs is very helpful in decision making, whether you are an economist or an average Joe.

Consider the cost of going to see a movie. If its a new movie and a decent theater, you’ll probably end up spending about $8 (sans soda and popcorn).  You can consider the direct cost of the movie to be $8 and two hours of your time. The opportunity cost is different. It is measured by what alternatives you are giving up by going to see a movie. While the direct cost of a movie is $8 and two hours, the opportunity cost is an additional $20 dollars if you could be working for $10 an hour during that time. In other words, by going to see the movie you are not only giving up $8 and 2 hours, you are also giving up the $20 you would have made, had you spent the time at work.

Opportunity costs bring insight to seemingly obvious decisions. Consider the cost of going to graduate school. Intuitively, you would determine this cost by totaling the cost of tuition, room and board, books, and school supplies over the required years at your university of choice. But lets look closer. What are the alternatives? First of all, room and board shouldn’t even be considered because you’ll need to pay for room and board whether or not you go to grad school (that is, unless you are heading back to Mom’s basement). Also, by deciding to go to grad school, you forfeit the money you would have made had you entered the work force upon getting your bachelors. For an accountant getting an MBA, that cost is likely over $100,000 (plus everything you could have done with that money). While many studies (like this one) have been done to determine if grad school is worth the investment, this exercise shows that seemingly straightforward decisions often have elements we fail to consider.

While opportunity costs make the economic world go round, sometimes they bring about surprising results. For example, this article in the Economist mentions a company in China that pays professional gamers to spend 60 hours a week playing World of Warcraft. While they play, they level up their characters, collect gold, and find valuable items, all of which can be sold to Americans for real US dollars. You can call these Americans lazy if you wish (they’d rather pay somebody else to level up their characters than do it themselves) but it makes perfect economic sense. In the time it would take Chris in California to level up his character, he could have earned thousands of dollars working at a high paying American job. On the other hand Li-Hong in Nanchong has much less lucrative alternatives. Because his opportunity cost is lower than Chris’s, he should spend his time playing the game and sell the gold, characters, and items to Chris. If he charges somewhere above his opportunity cost and below Chris’s opportunity cost, both people will benefit from the transaction. So is there a business model in playing World of Warcraft? If you are Chinese, the answer is yes!

Another surprising insight that comes is the value of family time. The more a person earns, the greater the opportunity cost of taking time off. For example if a private attorney takes the afternoon off to watch his son’s baseball game, he basically forfeits hundreds of dollars, where the McDonald’s manager only gives up $30 or $40. How much is it worth it for you to watch your son play baseball? How much would you have to earn before the cost is too great? These are the kinds of questions you will have to consider when deciding to not to work during baseball games, Sundays, or family vacations.

At the end of the day opportunity costs aren’t just about money… they’re about opportunities. Sure, by seeing the movie you may be forfeiting $20, but that isn’t the only opportunity you could be giving up. You could be using your two hours to practice the piano, call an old friend, read a story to a child, or serving at soup kitchens. In every thing we do, we weigh the cost against the benefits. By looking at opportunity costs, we add the alternatives into the equation. It’s important for us to recognize these opportunity costs in order to determine the best ways to use our time.

It is, after all, our most precious resource.