We all have a “drawer” with everything we gave up in taking any decision. In economics, what you give up is called an “opportunity cost”. How can we know if we came out ahead in the long term?
It’s a Friday evening after a long week of work and we have set aside a little money to do something fun. We have to choose between the cinema or going out for dinner. The option we forgo will be our opportunity cost. If we chose dinner, our opportunity cost would be the price of the meal, plus what we gave up by not going to the cinema.
When we acquire something, we pay two costs: the price we pay for it and the cost of what we have given up to acquire it. With our money, if we choose to invest it, our opportunity cost will be not having saved it; if we decide to save it, our opportunity cost will be not having invested it.
Understanding opportunity cost is useful because we can know what we will no longer gain by making a particular selection. By keeping it in mind we can take better decisions. To better understand opportunity cost in financial decision-making, we must consider two main factors. First, being aware of the opportunity we will forgo leads us to take better informed decisions. Second, it encourages us to compare the different prices, benefits and advantages available to us.
What are our biggest nemeses when we take a decision? Insufficient time to calculate costs and weigh advantages and disadvantages often leads us to take hasty decisions. Other times, we are incapable of feeling or seeing the costs and benefits in the short term. Spending time to get duly informed can help minimise the costs of any decision, including opportunity cost.