One of the most basic principles of economics – opportunity cost – according to the Economist’s definition, is ‘the true cost of what you have to give up to get it.
Brad was shopping for his first hi fi stereo and had spent an hour debating between a R6 600 Pioneer and a R5 000 Sony. Fearing Brad’s indecision might cost him a sale, the salesman interjected saying “Think of it this way – would you rather have the Pioneer, or the Sony and R1 600 worth of CDs?”
Brad’s face lit up. The decision was clear, the Sony – and by a large margin. Fifteen new CDs were too great a sacrifice for the slightly more attractive Pioneer. Although Brad was quite capable of doing the math, he hadn’t considered that until the salesman pointed it out.
One constant in all our lives is that we must make choices. You make choices from the time you get out of bed in the morning until you go to sleep at night. All decisions involve opportunity costs, no matter the size of the decision.
Opportunity cost is your next best alternative – your second choice – and something you value. A brilliant ad by De Beers depicted two large diamond earrings with the tagline “Redo the kitchen next year.” Implying the cost of the diamonds was merely a slight delay in a renovation.
Why is opportunity cost important? Opportunity cost is what you give up when you make a decision. When you ask yourself what you are giving up when you make a certain choice, it forces you to think more critically about all of the other options that you are not choosing. It also forces you to think about the follow-up question connected to your decision – is it worth it? You may find that when you think clearly about all of your options and identify the opportunity costs of your choices, perhaps your choice is not worth what you will choose to give up.
How much is your time worth?
Your time is valuable, but how much is it really worth? When your flight is delayed by two hours, you might say ‘what a waste of time’ but do you ever say ‘that’s R1 000 of my time down the drain? It’s whatever your salary works out to per hour.
The opportunity-cost equation simply tells you what the cost of your time is, not how you should spend it or how you want to spend it. If you would prefer to read a book than work another hour, that says that you value the time relaxing more than your salary rate. All this calculation gives you is a benchmark against which to consider what you are doing with your time. The crucial application is in thinking about how you want to spend your time
Consider stationery shopping. You can order through your stationer and have the supplies delivered in a day or two. Or you can go to a wholesaler and spend two hours out the office. There’s no delivery fee for the former, but maybe there are higher priced items and a markup. Which is the better way to shop? This opportunity-cost idea makes the decision easy: Is the markup or higher prices smaller than the value of two hours of your time? If yes, delivery. If no, head to the car.
Applying opportunity-cost theory won’t always change your behaviour but can simply be a useful tool to understand why things are the way they are.