Every time you travel down one path, you miss out on the path you didn’t take. It’s something we rarely think out, because missing something causes regret. We want it all.
But it’s a fact: we can’t have it all. We have limited resources, and it’s good to accept that. At any given time, there’s only so much money (or net worth) we have, but there’s an unlimited number of things we could spend that money on.
Once you can accept the “limited net worth, unlimited stuff to buy” dilemna, you can take steps to deal with it, i.e. by making good choices.
This is where the concept of “opportunity costs” comes in. An opportunity cost is the next best alternative you give up: so if you turn right at the bend, the opportunity cost is the opportunity of walking left.
If I decide to buy lunch at work, I may pop into McDonalds to pick up a cheap, convenient meal for $6. My other choices may have been a more expensive meal, chips and lollies from the vending machine, or a nutritious but time-consuming $3 home-cooked meal. Let’s assume of the remaining choices, I prefer the home-cooked meal: that’s what I’ve given up in favor of the McMeal.
What have I given up? Well, in my list of priorities, the first thing I sacrified was nutrition value. I’m desperately trying to eat healthy on a budget, and McDonald’s is the easiest way to blow both – more expensive, and more unhealthy. The second thing I sacrificed was $3. That’s not much money, but if I think of it in terms of something more tangible – maybe a coffee with a friend, a nice time spent chatting in a cosy cafe – I realize that I did give up something else of value. Finally, I gave up the inconvenience of making a home-cooked meal, which is really the only reason I’d only ever eat at McDonalds (I make a meaner burger at home ). So it really might be worthwhile to give up a cheaper, healthier home-cooked meal in favour of McDonalds if I’m going through a particularly busy time and can’t make time to cook.
That was an easy choice. A more difficult one may be, you want to buy your partner an expensive, romantic dinner. It would be a sumptuous meal and an experience that you’d both remember, and would cost $70 for two people. The next best option for spending that money would be to save towards a holiday. You could, of course, save the money for retirement, but I’m assuming you also want to live a little, strengthen your relationship and create some memories. It’s a tough choice, because both the dinner and the holiday are things you want. How you decide to ultimately spend that money is really up to your priorities. However, the important thing is identifying what you’re giving up. If you pick the dinner, you’ll have to wait a little longer before going on holiday. If you pick the holiday, that’s a special evening you’ve sacrificed.
I think that’s what the importance of opportunity costs really boils down to: acknowledging that they’re there. That you’ve given up something to get something. That your new car represents a new furniture set you didn’t buy. Accepting that opportunity costs exist means admitting that you can’t have it all, and that you’re being realistic about the fact that you need to make choices.
Costs, Part 2 – Sunk Costs is coming soon!
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