Opportunity Cost Principles Notes
Opportunity Cost Principle
Definition: The true cost of something is the next best alternative you must give up to get it. Your decision should reflect this opportunity cost rather than just the out-of-pocket financial cost.
Core idea: Scarcity forces trade-offs; choosing one option means forgoing others.
Practical implication: Use opportunity cost to compare the benefits and costs of choices across money, time, attention, and other resources.
The Cost-Benefit Principle
Definition: A good decision requires comparing the relevant benefits and costs.
Key takeaway: You should pursue a choice if the benefits are at least as large as the opportunity cost (benefits ≥ OC).
Note: Not all decisions are strictly "either-or"; more on that in the third core principle.
MBA Example: Nerida/Narada
Benefit of MBA: Better career prospects; MBAs earn around 10% more than comparable college graduates; more advanced degree may open more interesting work.
Costs to consider:
Direct out-of-pocket: Tuition ≈ $60,000 per year for two years.
Foregone earnings: If studying full-time, she would quit her current job and forego salary (example used: $70,000 per year).
Other costs mentioned: Room and board ≈ $24,000 per year (though some housing/food costs would exist in either path, so not all are OC).
Time and effort: Ten hours per day of studying; hard work required; non-financial cost.
Opportunity cost calculation (per year):
If Nerida pursues an MBA, the annual cost includes tuition plus foregone income:
ext{OC}_{ ext{per year}} = 60{,}000 + 70{,}000 = 130{,}000.Over a 2-year program, total opportunity cost = $130,000 × 2 = $260,000.
If she continues to work, she would earn $70,000 per year and incur housing costs (rent/board) of $24,000, but there is no tuition and no foregone income beyond continuing employment.
The opportunity cost of pursuing the MBA relative to staying employed is the difference between the two paths:
ext{OC}_{ ext{MBA (2 yrs)}} = 260{,}000.
Four lessons from the MBA example:
Lesson 1: Some out-of-pocket costs are also opportunity costs (e.g., $6,000/year tuition).
Lesson 2: Opportunity costs need not involve out-of-pocket costs; foregone earnings are a major OC.
Lesson 3: Not all out-of-pocket costs are true OC (e.g., room/board may be incurred in both paths; only the differential matters).
Lesson 4: Some nonfinancial costs are not OC (e.g., increased hard work is a cost of the MBA, but not an OC if the same effort is required in the next best alternative).
Conclusion for Nerida/Narada: The MBA is worth it only if the benefits exceed the total opportunity cost of $260,000 over two years.
Everyday Economics and the Road Not Taken
The road not taken metaphor (Robert Frost): The opportunity cost of taking one path is the road not taken; the next-best alternative.
Practical use: When making daily choices, ask what you give up by choosing one option over another.
Simple guidance: For any choice, ask two questions:
What happens if you pursue the chosen option?
What happens under your next best alternative?
The core formula reiterated:
The opportunity cost of a choice is the value of the next best alternative forgone.
ext{OC} = ext{Value/Consequence of next best alternative forgone}.
The Opportunity Cost Principle in Practice
General rule: For any choice (money, time, attention, etc.), there is an OC because resources are scarce.
If you can do multiple things, identify the best alternative and compare:
If benefits of the chosen option ≥ OC, consider choosing it.
Entrepreneurs and OC:
Starting a business involves two key OC questions:
Should you start a new business or stay in your current job? Foregone earnings from quitting a steady job are an OC of the entrepreneur's time.
Should you invest money in the new business or leave it in the bank? Foregone interest is an OC of the entrepreneur's money.
A venture is worthwhile only if the total benefits (including potential profits) exceed the OC of the time and money invested.
Sunk costs: Ignore sunk costs in decision making.
Definition: A sunk cost is a cost that has already been incurred and cannot be reversed.
Reason to ignore: Since sunk costs are incurred regardless of the future choice, they are not opportunity costs.
Everyday examples: People staying in unhappy relationships due to time already invested; corporate projects continued to avoid admitting sunk costs.
Sunk Cost and Its Misleading Influence
Common mistake: Letting past investments drive current decisions.
Principle: Only consider future costs and benefits when evaluating current choices.
Why it matters: Ignoring sunk costs leads to better decisions aligned with current and future opportunities.
The Production Possibility Frontier (PPF) and Opportunity Cost Visualization
Purpose: Visualize how to allocate scarce resources and the trade-offs involved.
Concept: Maps the attainable outputs (combinations) given scarce resources.
Example used: Study time for Economics vs Psychology with 3 hours available per night.
If 1 hour is allocated to Economics, Econ grade rises by 8 points; Psychology rises by 0 from that hour.
If 1 hour is allocated to Psychology, Psych grade rises by 4 points; Econ rises by 0 from that hour.
Frontier points form the boundary of the best feasible allocations.
Key insight: Moving along the frontier reveals OC—gaining more of one output requires sacrificing some of the other.
Example: Each extra hour to Psychology (4-point gain) costs 8 points in Economics.
Productivity improvements shift the frontier outward:
New study techniques or better efficiency allow more output from the same inputs, expanding the frontier.
Even with productivity gains, time remains a scarce resource; OC persists.
Summary of the Two Core Principles and Their Use in Decisions
Core principles:
Cost-Benefit Principle: Do it if benefits ≥ costs (including opportunity costs).
Opportunity Cost Principle: The true cost is the best alternative forgone.
Combined guidance: Pursue a choice if benefits are at least as large as the opportunity cost (i.e., the next best alternative).
Not all decisions are strictly "either-or"; later sessions will show how to reduce complex choices to simpler "either-or" decisions using a third core principle.
Ethical, Philosophical, and Practical Implications
Ethical: Considering OC helps allocate scarce resources fairly and efficiently, avoiding wasteful commitments.
Practical: Encourages long-term thinking about time, money, and attention rather than short-term out-of-pocket costs.
Psychological: People often misperceive costs by overemphasizing out-of-pocket amounts and ignoring non-financial trade-offs.
Practice Questions and Thought Experiments
Should you hang out with friends on Saturday afternoon or study for Tuesday's exam?
Should you devote time to an extracurricular leadership position or study for straight A's?
Should you add an unpaid internship this summer or continue waiting tables?
Should you hire your best friend to work in your family business or hire someone else?
Should you invest savings in the stock market (higher expected return but higher risk) or in the bank (lower return but safer)?
Should you sell internationally or keep sales domestic?
Should you spend all current earnings now or save some for future spending?
Your answers depend on your personal situation; the point is to apply OC and CB analysis to your life choices.
How to Apply These Ideas to Your Life
Use OC to evaluate college decisions:
Tuition vs. foregone earnings; room/board differential; time commitment; nonfinancial costs.
Remember: The largest OC for college often is the foregone earnings during the years of study.
Use OC and PPF to plan study time, career decisions, and entrepreneurial ventures.
Use the "or what" rule to force explicit consideration of alternatives in any decision.
ext{OC} = ext{Value/Consequence of next best alternative forgone}
ext{Total OC (MBA 2 years)} = 2 imes (60{,}000 + 70{,}000) = 260{,}000.