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Are strawberry smoothies considered a good idea by economists? Instead, the flavor of the Kiwi will depend on how good it is, as well as other options. This concept is called opportunity cost.
What is the source of opportunity cost in everyday life?
Andrea Caceres-Santamaria, senior economic education specialist at the St. Louis Fed, writes about opportunity cost in the recent Page One Economics: Money and Missed Opportunities article.
The Scoop on Scarcity
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In life, nothing is possible. There is a scarcity factor involved. In spite of our unlimited wants, we have limited access to goods, services, money, time, and opportunities. According to Caceres-Santamaria, the concept is what drives choice-and, by extension, costs and tradeoffs.
She gives the example of choosing to buy a $7 smoothie at the mall. She believes that most people would simply view the choice as a question of whether they want the drink or not.
Rather than wearing "economist glasses," she suggests looking at the decision differently, asking:
- What is the value of this to me?
- What do I give up now in order to have it?
- What do I give up in the future to have it now?
Costs That Are Seen and Unseen
The trade-offs a person makes can also affect their professional and personal well-being over time, despite our tendency to focus on immediate financial matters.
Aceres-Santamaria suggests that in the process of decision-making, we should not only consider explicit alternatives - choices and costs - but also implicit alternatives - i.e., "unseen" opportunity costs.
The idea is to be able to think beyond the current situation and consider other options for spending the money.
Do you have any other examples of opportunity costs?
- A student spends $20 and three hours at the movies the night before an exam. Time spent studying and money spent on other activities are examples of opportunity costs.
- The farmer decides to plant wheat, but the opportunity cost would be planting a different crop or using the resources (land and farm equipment) in a different way.
- In Nigeria, people take the train instead of driving to work. The train takes 70 minutes and the road takes 40 minutes. Those minutes could have been spent doing something else.
Is Opportunity Cost a Big Deal?
Losing study time or spending $7 on a smoothie may not seem like a big deal, but how about bigger choices like buying a more expensive home versus a starter home, or spending $1,500 more for an upgraded trim package on your next car?
Aceres-Santamaria points out that when making high-priced purchases, opportunity costs are ignored even more. As an example, the $1,500 upgrade to the base car price of $18,500 might be considered a relative value by a consumer.
It might be more useful to consider what else $1,500 can buy, rather than comparing a more expensive vehicle with its fancier configuration.
Why the Rush?
"Most of our money decisions involve immediate consumption or consumption sooner rather than later," observes Caceres-Santamaria. Today's excitement is worth much more than thinking about tomorrow's."
As humans, we are impatient. Immediacy of a promised benefit often tempts us over a long-term payoff.
There is value in examining the future value of money-a concept that many of us have heard about in retirement plan literature.
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The Future Value of Money
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Example 1: The one-time windfall
Let's say you got a windfall of $4,000 and you want to take a trip with it. Can't you? Considering the opportunity cost, there's no loss for you. Since this is found money, you're not losing anything.
If you invested in an income-producing product at 3% annual interest, compounded monthly, you would earn $5,397 in 10 years.
In five years, your funds will have grown to $6,270. These examples do not take inflation into account.
That's an added benefit if you think about it financially. Moreover, you should consider the experiences that an extra $1,400 or more-the future earnings on your $4,000-would enable you to have.
Example 2: Small, regular savings over time
Investing one lump sum over a long period of time. Daily purchases, such as your $3.49 caffè mocha three times a week, may not be considered when calculating the opportunity cost. How much money would you have if you invested $54 every month instead of spending it?
With $54 per month invested and 3% compounded monthly, you'd have $7,619 to dip your doughnut into in 10 years if you dropped the coffee (carefully!).
Do you think it's too long to give up that regular mocha? Even by reducing the timeframe by half, you will still save $3,554. Please note that these figures do not include inflation or taxes.
Even when you consider that spending $4.49 on a caffè mocha habit over time dwarfs spending $4,000 on a vacation.