What is an Opportunity Cost?
You walk into the grocery store and decide you are going to buy groceries within your weekly budget ($100). As you checkout, the cashier goes over that $100 limit. You immediately have to make a decision:
- Do you get all the items that have gone through? OR
- Do you put back some of the items to make certain you are under that $100 budget?
Consequently, this decision requires you to think about the opportunity cost. If you purchase all the items (costing more than $100), what will you be giving up to make that possible? You are forced to make the decision:
- Are you willing to go without this food? OR
- or Are you going to choose to get this food?
Going over your $100 budget would mean not paying the rent bill on time for your house. Therefore, the opportunity cost of having to pay a late fee on your rent is not worth the extra grocery items. An opportunity cost is like a trade off between what you would like and what you can afford.
Unfortunately, every decision closes off alternatives. Opportunity cost is what you give up by making a choice. However, Dollars are not always the measurement for the trade off- It only represents the resource that you give up for which a value is lost. Another example might be time. The decision to purchase new car tires:
- Waiting- causing the risk of getting a flat tire OR
- Going to the first shop next door to replace the tires- reducing the risk of getting a flat tire
Therefore this risk, is the uncertainty, which is a part of every decision. You do not know that you will or will not get a flat, or even how long your current tires are going to last. Other decisions involve a very low amount of risk. As an example: spending an extra $5 at the grocery store from your budget or having that $5 for toll roads during the work week. Evaluating risks can be difficult. The best way to consider the amount of risk for each situation is based on your experience and experience of others.
With every financial choice, it is the consideration of what you give up in time, effort and money. When you look to purchase a home versus rent, each deciding factor will look at an opportunity cost:
- The interest earnings lost on the money used for a down payment on a home VS. the security deposit for an apartment.
- The time and cost of commuting to work when you live in an area that offers less expensive housing VS. more living Space.
- The loss of tax advantages and equity growth when you rent a city apartment to be close to your work.
- The time and money you spend when you repair and improve a lower- priced home.
- The time and effort involved when you have a home built to your personal specifications.
Kinds of Opportunity Costs
Personal Opportunity Costs
- Time for one opportunity will be lost time for another
- Poor eating habits may increase health care costs
- Lack of sleep will take time away from school or work
- Avoiding exercise can cause higher financial responsibilities
Managing your time, energy, health, abilities and knowledge can help to avoid unfortunate events.
Financial Opportunity Costs
Would you rather have $100 today or $105 a year from now?
- Based on current needs, future uncertainty, and current interest rates
- You will want to be rewarded for the risk if you wait to receive money
If you have ever heard of the term “time value of money,” they are simply referring to this financial opportunity cost: $1 today is worth more than $1 tomorrow.
Readers, what kind of opportunity costs do you have to regularly face and how do you typically handle them?