In America student loan is close to $1 trillion. If you ask a college student what is the cost of going to college. They will tell that it is their loan. But that is a sunk cost. It means that the cost is already incurred and it cannot be changed. The real cost is what they could have done if they had not gone to college. The wages foregone if they had taken up a job or the time lost in mastering a skill are some of the foregone options. This hidden cost is the opportunity cost.
Opportunity Cost is what you have to give up in order to get something.
I purchased a home by taking a mortgage. I had to make a down payment of 20%. I was very happy with my decision. But I never thought about what I could have done with that 20% if I had not purchased the house. I could have used that money to start a business. I could have gone for a world tour. From the book The Paradox of Choice
Failing to think about opportunity costs can lead people astray. I often hear people justify their decision to buy a house rather than continue renting by saying that they are tired of letting a landlord build up equity at their expense. Paying a mortgage is investing, whereas paying rent is just throwing money out the window. This line of thinking is fair enough, as far as it goes, but it doesn’t go far enough. Here’s how far most home buyers take it: “I have to make a down payment of $50,000. My monthly expenses, including mortgage, taxes, insurance, and utilities, will be same as they would be in a rental. So, in effect, for an investment of $50,000, I get to have monthly housing costs work for me, building up my equity rather than my landlord’s. And I’m sure that I’ll get more than that $50,000 back when I sell the house.”
No doubt about it, owing your own home is usually a smart investment. But what buyers leave out of this line of reasoning is the opportunity cost of putting that $50,000 into the house. What else could you do with it? You could put that $50,000 into stocks or Treasury Bill, or you could use it to finish law school and increase your earnings, or you travel around the world and write that novel that you hope will utterly change your life.
Learning from Charlie Munger
This is what Charlie Munger tells about opportunity costs.
I just wanted to do the best I could reasonably do with the talent, time and resources I had available. That’s what I was doing then and now. Everything is based on opportunity costs. Academia has done a terrible disservice: they teach in one sentence in first-year economics about opportunity costs, but that’s it. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to.
In another writing Munger explains how Buffett uses opportunity costs to make investment decisions
So, when someone presented a company in an emerging market to Warren Buffett, Warren said, “I don’t feel more comfortable [buying this] than I feel about adding to our position in Wells Fargo.” He thinks highly of the company and the managers and the position they were in. He was using this as his opportunity cost. He was saying, “Don’t talk about anything unless it’s better than buying more Wells Fargo.” It doesn’t matter to Warren where the opportunity is. He has no preconceived ideas about whether Berkshire’s money ought to be in this or that. He’s scanning the world trying to get his opportunity cost as high as he can so his individual decisions would be better.
Production Possibility Frontiers
Opportunity cost can be illustrated by using production possibility frontiers (PPF). The term sounds technical but it is very simple. A PPF shows all the possible combinations of two goods available at one point in time. Imagine you can do only two things for an entire year. You can watch movies and read books. In the table there are six scenarios. In scenario A if you watch 52 movies for an year then you cannot read any books. In scenario C you can watch 28 movies and read 10 books.
|Scenario||No of movies watched||No of books read|
You are now in scenario C. You can watch 28 movies and read 10 books. Now you go to scenario B. You can watch 40 movies. What is your opportunity cost? You can only read 5 books instead of 10. Hence your opportunity cost is 5 books.
Why considering opportunity cost is hard?
Our brain only see what is there in front of our eyes. This is called as an Availability bias. Hence we are blind to other opportunities and this gets ignored in most of the cases. Daniel Kahneman defines this by the term WYSIATI – What You See Is All There Is.
Is there a solution?
Have a checklist and add opportunity cost as one of the item. Before making any major decision in life refer to the checklist. This way you will at least make an attempt to consider other alternatives. Checklists are powerful. If you want to learn more about checklists read the book – The Checklist Manifesto: How to Get Things Right by Atul Gawande.