When I was studying at school, the examples that were used to explain financial concepts were all textbook examples. Blah! It did help me understand concepts but never really made me understand the real world application of these concepts. So let me explain opportunity cost using language that you can relate to and help bridge the gap between theory and application.
The concept of opportunity cost
We make a number of decisions in our day-to-day lives. Often we find ourselves in a state of dilemma where we are presented with multiple choices but aren’t sure about what option to go with. Let each of these choices represent a different opportunity. We consult with our friends and family, to understand the payoff related with each opportunity, and get their input on which option to select. Eventually we make a decision. What helps us make this decision?
Well, we weigh the pros and cons of each of these opportunities and try to analyze that in perspective of the subsequent payoff. However, in going with one of the opportunities, we are required to let-go of the other ones. In other words, going with one opportunity is costing us the other opportunities. Thus, the payoff associated with the second best opportunity that we had to let-go of, is the opportunity cost of selecting the option that we chose.
Opportunity cost of an option is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives.
Love it! Now back it up with an example!
Steve works at an investment bank and earns $100,000 a year in salary. However, he isn’t the kinds to sit behind a desk all day and crunch numbers. He wants to build something from the ground up, be the face of his company and venture out. So he decides to quit his job and be an entrepreneur.
His startup has slow beginnings and ends up grossing him $12,000 of personal income in year one, since he spent most of the first year in just building the team, getting proof of concept, and identifying a revenue model. Compared to the $100,000 he made at his old job, $12,000 is a really low income. His opportunity cost of being an entrepreneur is $88,000 for the first year.
However in the second year, he ends up striking a crucial partnership that boosts revenues for his startup, and he eventually ends up earning $110,000 in personal income. Also, the value of his equity stake in the startup is $700,000. Thus the opportunity cost of being an entrepreneur in the second year is -$710,000.
Therefore it is important to also take timeline into consideration when you think of opportunity cost. Something that your textbooks will not teach you is that there are many non-mathematical payoffs associated with certain opportunities. Like in the above example, being an entrepreneur also helps Steve get recognition in the society as someone who has the confidence to bank on his vision. This earns him a lot of respect, which you cannot really put a dollar amount on. So keep in mind that opportunity costs are a combination of numeric and non-numeric payoffs.blog comments powered by Disqus