Hello!

Thesis: Each decision we make has a cost associated with it. If this cost is not properly accounted for, strategic initiatives and personal decisions may be made foolishly and may impact future decisions.

If you haven’t read my Introduction to Economics, I’d highly recommend it before reading this article as some of the terminology associated with this subject may be difficult to understand.

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Cost of Making a Decision

Decisions have costs. In economics, we call these opportunity costs.

Opportunity costs are the value of the next-highest valued alternative use of a resource.

Unfortunately, we live in a world that has scarcity. There are limits to what we can do. No matter how productive we become, we can never accomplish and enjoy as much as we would like. Because of scarcity, every time we do one thing we necessarily have to forgo doing something else desirable.

The whole idea is that an effective decision is one in which you give up something (use a resource) and get something better out of it, so you end off better.

Opportunity Cost = Value of Option Not Chosen - Value of Option Chosen

The thought is that if the cost of the next best alternative is higher than the cost of the resources employed in the decision, a rational person would not make the decision, and would, instead, choose the first option.

Given the definition of opportunity cost above, what types of resources can you use in decisions and how do their opportunity costs work?

Money

Money is an easy example of opportunity costs. Opportunity costs with money have 2 variables associated with them.

When you choose to use the money, an opportunity cost could be whatever else you could have purchased with that money. This could be a thousand different things, but it all relates to the concept of perceived value. Essentially perceived value is the perceived benefit of the option minus the costs.

The perceived value of the next best alternative is your opportunity cost.

When using money, there is also the opportunity cost of not using the money. This means saving or investing the money to be used at a future date. If you expect you can get more value for your money at a later date, then a rational person would not use the money.

Combining the cost of not using the money and the cost of using the money on something else and ranking the best alternatives gives you an effective estimate of the opportunity costs of using money in a decision.

For example, if you have the opportunity to decide to purchase food for $5, you receive a perceived value of $10. The opportunity costs in this scenario would be the cost of not using that $5 to purchase clothing (a perceived value of $8), or the cost of not saving/investing that money (a perceived value of $6).

Even though your opportunity costs are higher than the inherent value of the money (you are better off in any scenario), you still would choose the “best” option, in this case buying food for a value of $10.

Labor

The opportunity cost of labor is the cost of using your human resources to achieve something. Simply, this means the idea that focusing on one task prevents you from doing or making progress on another activity.

For instance, choosing to work on one project at work instead of another.

This opportunity cost is difficult to calculate. As you’re substituting one project for another, the opportunity cost in this case would be the perceived value of the next best project you could be working on or use of your labor.

Physical Resources

The opportunity cost of using physical resources is the next best alternative use of that asset. There are many types of physical resource opportunity costs.

Consider these examples:

• You decide to use unused land to build a new factory - next best alternative: selling that land on the market
• You decide to use a factory to produce stuffed animals - next best alternative: using that factory to produce furniture

In all of these scenarios involving the use of physical resources, the perceived value of the next best alternative is simply the other uses of that asset.

Time

Many decisions require you to give up your time to get something. This is the most common example of an opportunity cost, happening constantly.

Consider the following decisions and opportunity costs:

• You choose to sleep in - next best alternative: waking up and going to exercise
• You choose to read - next best alternative: relaxing

With decisions involving time, the opportunity costs are hard to truly understand. What exactly is your time worth?

Consider the opportunity costs of being lazy. Many people would simply equate the opportunity cost as the value you would be earning if you worked for that hour, or simply put your hourly wage.

But, you weren’t going to work for that hour, so that wouldn’t be considered an “alternative” in this scenario. The cost of your time would be what you would actually do instead of being lazy, maybe the perceived value of cleaning, the perceived value of sleeping, or perhaps the perceived value of exercising.

See how the cost of your time can be extremely difficult to calculate?

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Complexity of Opportunity Costs

Consider the following example: If you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else. What would be the opportunity cost in this scenario?

It would be a combination of what you could use that money and time on if you weren’t going to the movie. That combination of possibilities makes calculating the opportunity cost of going to the movie more difficult.

Yet, your brain can do this in the space of a second.

In a decision, there are many different parts.

1. How much do I value this?
2. What am I giving up now to have this?
3. What am I giving up in the future to have this now?

These lead to the opportunity costs. The best alternative to the decision involves two types of alternatives. Explicit alternatives and implicit alternatives.

Explicit alternatives are the choices and costs present at the time of decision-making. These are generally the alternatives that most people think about when deciding.

Implicit alternatives are the unseen opportunity costs. These costs are much harder to measure as they are usually qualitative and many times hidden.

Yet, to make a rational decision, one must consider all explicit and implicit alternatives.

While opportunity costs can’t be predicted with absolute certainty, they provide a way for individuals to think through decision options and, ideally, arrive at better decisions.

Anywho, that’s all for today.

-Drew Jackson