Opportunity Knocks!

This is the first in what will probably become an ongoing series of very basic and loose guides to Economics theories, concepts and terms.

 

I’ve never studied Economics, and am only just starting to learn more “formalised” concepts at the ripe old age of 36.

 

As I go about my learning, I’ll be writing these pieces as a reminder for myself – consider them my course notes.

 

Today’s Lesson

 So let’s get going! Today, and for no particular reason, I’m starting with Opportunity Cost. This is a phrase you will see littered around personal finance and investing blogs, but what does it mean?

 

Even if you’ve never heard the term before, I guarantee that you know what it is. Almost every one of us is weighing up Opportunity Costs all the time. I mean, several times a day, every single day of our lives.

 

Definition

Let’s start with a definition, from Wikipedia:

 

“.. the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the “cost” incurred by not enjoying the benefit that would be had by taking the second best choice available.”

 

Hmmm. I don’t know about you, but I find that a bit hard to get my head around, at least until I’ve read it a couple of times. Let’s see if we can put that a bit differently.

 

In A Nutshell

  •  Decisions that we make involve either time or money (or often, both time and money)
  • For every use we can put to each pound coin that we possess, there are many other options available to us for that pound coin
  • Or, for every minute of our day we spend doing one particular task, there are many, many other tasks we could be doing instead
  • Those other options that we had? Each one represents an Opportunity Cost, because in not choosing them, you’re missing out

 

Example

You buy a new bike. The bike costs £500. In addition, every year you will spend £50 on maintenance.

 

Now, you had plenty of other options for that initial £500. You could have put it in a bank account and received, say, 5% interest from the bank. The £500 would be “earning” £25 a year. That’s an Opportunity Cost, because you didn’t put that money in the bank, you spent it on a bike – so you’re missing out on an “income” of £25 a year.

 

Add that £25/year that the bank would have “rewarded” you with, to the £50 a year you’re also now spending on bike maintenance, and you’re effectively £75 a year down on your money because of buying the bike.

 

(As a good trainee economist, hopefully you went through a thought process along these lines before splashing the cash on the new wheels, even if you weren’t aware of the name for what you were considering: The “Opportunity Cost”)

 

Taking it a bit further though, maybe you plan on riding the bike to work 3 days a week instead of using the car, and thus you worked out that you’ll save £15 a week in petrol and maintenance costs by doing this? In a 47 week working year, that’s £705 a year that you’ll be saving on petrol. So even after accounting for the missed bank interest and the bike maintenance costs, now the investment in the bike is returning more than the first alternative that we’ve considered.

 

Let’s take it a bit further.. in riding the bike to work 3 days a week, you’re improving your overall health and getting fitter. This should hopefully pay long-term dividends in that you probably now have a lower chance of suffering from obesity, and maybe you’ve reduced the chances of suffering something like a serious heart problem in later life too. So now, buying the bike also becomes a good punt on reducing health care costs (not to mention the time off the road!) and maybe even buying you more life-time further down the line.

 

On the other hand, you’re chances of getting knocked off a bike are now infinitely greater than they were previously, so maybe you need to take that into consideration too…

 

 

Don’t Let It Get You Down

By now we’re seeing that this thought process could go on and on, and it’s a reason why some people can find the idea of Opportunity Cost rather depressing! Most of us are afraid of making the “wrong decision” or even just a “bad decision”, where actually, often the worst thing you can do is not making a decision at all. (Incidentally, my philsophy is that, generally speaking, there are no “right decsisons” and “wrong decisions”, but that’s for another day.)

 

An alternative to over-extrapolating the thought process of considering Opportunity Cost is just to follow Danny Wallace and become a Yes Man, but conventional wisdom would probably suggest that the best solution for most of us lies somewhere in between the two extremes. With the bike example then, maybe the process would go something like this:

 

  • Realise that you want the bike
  • Decide if you can afford it (and I mean without borrowing dosh)
  • Think about how much you’ll use it, if there’s another use for the money that you consider a more-preferred option at this time, and if it’s “worth the money” (that’s quite difficult to do, assessing the value of something – I’ll no doubt write about it later on in this series)
  • Make an informed decision and get on with life

 

Time Is Money

Like I said, we’re all doing this, all the time. That’s because there’s an Opportunity Cost to the things that we do, including those that don’t necessarily involve money.

 

Whenever you do “a thing” there are plenty of other “things” that you could be doing instead. You just spent 5 minutes reading this blog. Maybe you could have spent that 5 minutes doing star jumps, or making a sandwich, or making love (twice), or ringing the gas company about that funny smell, or reading someone else’s blog. You did none of those things – unless you’re making love whilst reading this, in which case, I salute you, and I somewhat pity your partner(s) – and so there’s a “cost” involved with that spent time (and if you should really have been ringing the gas company, let’s hope you’re not about to pay the ultimate Opportunity Cost).

 

So when people use an over-worked phrase like “That’s an hour of my life I’ll never get back!” what they are really saying (whether they know it or not) is that they are considering the Opportunity Cost. They are saying “Oh, the things I could have been doing in that time!” [1]

 

Enough For Now

Right, that’s it for Lesson One, thanks for your time. The sun’s back out, time to get out on that bike! [2]

 

JAL

 

 

 

 

 


[1] More often than not, I hear this phrase used in an office environment, and usually when people come out of a meeting. In which case, the list of alternative options for their time probably extends to “Checking Facebook 27 times” or “Fetching a round of coffees and having a bleat about the roadworks/the spouse/the PM/the state of English sport”.

What these people are usually forgetting is that they work for The Man, and if The Man says you go to the meeting, well, sadly, most people go.

 


[2]  I should probably fess up at this point that, coincidentally, I’ve just bought a new bike 😉

As a quick justification to my more frugal side:

  • I considered the Opportunity Cost – and I probably hung around a bit too far on the non-Danny Wallace end of the scale
  • My previous bike was way past its best, was becoming downright dangerous, and I didn’t consider it worth fixing up. I ride a bike instead of using any fossil-fuelled vehicle wherever possible
  • I waited and waited for what I would consider a real bargain to present itself
  • And I’m considering calling the new bike L’Oreal, because I’m worth it

 

Justification over.

 

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