Applied Opportunity Cost

Opportunity Cost is a concept from economic theory that describes a cost that is measured in the value of the alternative forgone. Simply put, it’s what you’re potentially missing out on by doing something else. This is a very important concept for efficiency and productivity, especially when you realize the numerous ways it can be applied to your life.

The Economics

Let’s look at that definition again:

The cost measured in terms of the value of the alternative forgone.

What this is basically saying, is that if you have 2 options, A and B, the opportunity cost of doing A, is the value you would attain from having done B, as measured by B’s definition of value.

A super clear example from the real world is this: on a busy Friday night, an entrepreneur trades 6 hours of drinking/partying/catching up with friends time for 6 hours in the office. The opportunity cost, by definition, is the value attained from those activities he missed out on. In this case, that value can be quantified in say happiness units or enjoyment units.

But it’s more complicated than that. Because you can also factor in, the additional value that those 6 hours of work created. And the potential loss of monetary value from going out to dinner or buying rounds of drinks.

To factor these things in, we need to look at opportunity cost through the lens of application, rather than just theory.

The Real World

When it comes to applying the concept of opportunity cost to the real world, we can’t use potentially-subjective measurements like “happiness units”. We can really only objectively quantify time and money.

Note: AE Thanh would like to remind readers that time is lost forever, but you can always make more money.

Money

Let’s start with the easy one: money.

I say money is the easy one, as most things can be quantified into a financial value, and because money is a renewable resource, you have essentially infinite alternatives (i.e., if you don’t buy item A this week, you can wait until next week’s paycheck and buy it then).

The best way to calculate the opportunity cost of money is through tracking your income and expenses, and calculating your real hourly wage (credit: Your Money or Your Life).

You can use any simple tracker on your smartphone, like iXpenseIt, Money or MoneyWell, or even just use pen and paper. At the end of each month, tally up your expenses and income and see what they are.

To work out what your real hourly wage is, write out how much you make a year, then calculate the amount of time you spend at work and on work-related activities. You want to first deduct work-related expenses from your salary/income figure, like uniforms or clothing or transportation, and you want to factor in travel time, overtime and other work-related events outside your normal working hours.

If you freelance, you can extrapolate your time tracking data for a month into a year and use that to calculate a similar figure.

Now here comes the interesting part. Take each expense item, and work out how many working hours it took you to purchase that. To do that, you want to take the value of the item and divide it by your real hourly wage.

As an example, say you calculate your real hourly wage to be $12 an hour. Each Friday night, you spend $60 on drinks with workmates. That means that it takes you 5 hours to “work for” those drinks.

Based on this, you want to ask yourself if the 2 hours of drinking with friends at a bar on Friday night, is really worth 5 hours of work – and what the opportunity cost of those 5 hours is, both in monetary and other value terms. For example, $60 could equal 2-3 days of eating out. It could also equal a year’s subscription to MacWorld. It could also equal 5 extra hours to spend with your family.

This is what we mean by applied opportunity cost – it isn’t always clear exactly what we’re forgoing when we make purchasing decisions.

Time

Unlike money, time is not something you can earn back. Once time is gone, it’s gone forever. An additional compounding factor of this, is that there are certain things that you can only do at one point in time, and will never have the chance to pursue that opportunity again. These are the things that you want to look out for – the things that if you pass up now, will never be available to you again.

For example:

• Time-sensitive business offers and opportunities.
• Noticing someone you’re attracted to walk past you on the sidewalk, and deciding whether to go say hi.
• Exercise.
• To stay in a (toxic) relationship or not.

In addition to these opportunities which disappear forever, you can also interchange time with a monetary value to calculate opportunity cost. Taking your real hourly wage figure, you can decide if an hour of television is worth $12 to you. Or if that $60 shirt is worth 5 hours of television.

Health

Your physical health is also something that you can consider for applied opportunity cost. A greasy meal of burger, fries and soda might seem like the right thing to eat right now, but consider the later cost: more time spent at the gym, less energy later when the sugar-high crashes and less meals in the future (due to decreased lifespan).

Here at Asian Efficiency we think that physical exercise is one of the best things you can do with your time. It isn’t something you can do later, and it definitely outweighs the opportunity cost of forgone activities. Exercising properly will make you live longer, work more productively, enjoy life more and provide all sorts of social benefits.

Concentration and Motivation

Both concentration and motivation are renewable resources that become depleted through work and other activities. Because they are something you “spend”, you can use them to calculate opportunity cost as well.

For example, 40 hours of intense concentration on a work project, will likely translate into 2-3 days off for renewal. That 40 hours of concentration could also have been applied to other things: helping your kids with their homework, some personal projects at home, studying for GMATs and so on. Before you adopt the (unfortunately common) maxim that you should be working all the time, consider the value forgone in all these other activities.

You can renew concentration and motivation through downtime, and through lifestyle. Downtime includes things like mindless entertainment (TV, video games, going out), social time with people whose company you enjoy, vacations and breaks. Lifestyle is primarily about physical health and energy levels.

A Simple Example

To better demonstrate how all this fits into your everyday life, let’s look at some common examples of opportunity cost tradeoff.

1. Project Selection – which business/industry/career should I enter?
Entering a profession is the fastest way to a stable income, but entrepreneurship may pay off bigger dividends over time. But an entrepreneur has to live off savings while building their business, of which the monetary value could have been invested in other things during that startup phase.

2. Stay at home to work late, or go out with friends?
Staying at home means you produce value in your business, but you lose social time with friends, which renews your concentration and motivation levels, and you also lose out on any enjoyment factor. But staying at home means you won’t be spending money on food, drinks and any other related activities, but you deplete concentration/motivation.

3. Stay at a job you hate with good money, or do something you enjoy with less money?
Staying at the job you hate provides you with monetary value. But you deplete concentration and motivation faster, as well as general overall happiness. Changing to the job you enjoy means less money, which means you may have to find additional sources of income and work for them, and it also means you have to forgo certain purchase that you would have been able to make with money from the job that you hate.

4. Money or Time?
An interesting concept is that having excessive cash “buys” you time, if you are creative with your personal outsourcing. Money buys technology and OPT (other people’s time), thus you can “create” time by spending certain amounts of money. Simple examples are outsourcing your tax preparations or laundry, or signing up for a service that say automates your bill payments or paying a travel agent to plan your holiday for you.

Notice that we haven’t given conclusive “which is better” answers to each of these examples – this is because the opportunity cost differs for every individual, due to everyone having varying amounts of the basic resources: time, money, health, concentration and motivation.

Next Actions

• Work out your real hourly wage. This will be incredibly useful for calculating opportunity costs forgone.
• Start making smarter decisions, with both time and money.

Photo by: visualpanic