Wednesday, May 16, 2018

291. You have to consider lost opportunities

Opportunity cost is largely a business term describing the impact of a decision to produce one product over another or invest in one company over another.

“Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action,” Investopedia describes it. “Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events.”

The last sentence is the key to understanding opportunity costs — it is the decision that comes at the expense of every other mutually exclusive choice.

It is a relevant and sometimes overwhelming concept that applies to not just financial matters but many other elements of our lives.

For example, if I go to law school, it comes (most likely) at the time and financial expense of going to medical school, bartending school or studying to be an architect. But it also applies to simple matters like what to do on Sunday mornings when you cannot be in two places at the same time. Going to Cedar Point comes at the expense of everything else you could do on that particular morning, such as go to church, have brunch with the family, or fly to Rome.

In terms of personal finance, some advisors have suggested that it is one of the most overlooked considerations of decision-making.

If I decide to buy a boat, I have to consider not just whether or not I can I afford to buy the boat but whether I should purchase the boat at the expense of everything else I could buy with that money. Should I buy the boat or a car? Or should I take 10 vacations or go out to dinner 500 times?

Too often we want it all and don’t think about how one thing affects the other — we just do it and hope to figure it out later. It’s the danger of credit cards — that which allows us to delay or spread out opportunity costs by not paying only what we can afford at a given point in time.

This distinction lends itself well to the discussion of local and national budgets. Whereas state and local governments have to balance budgets, the federal government, as we all know, can run trillions of dollars in debt.

Local governments, with a finite amount of projected revenue, have to make difficult decisions. Officials have to choose between adding another police officer, fixing up a city park, repairing a road, or buying a fire truck. For the most part, it is a good requirement as it attempts to prevent local governments from going into debt. The trade-off, of course, is that poorer communities — those that collect less in tax revenue — often see their services decline. There might be fewer police officers on the roads to keep the community safe or it might take longer for roads to be repaired.

Conversely, the federal government can fall in debt — currently to the tune of $21 trillion, according to the U.S. debt clock. That works out to almost $175,000 per American taxpayer. Of course, the federal government can also sell bonds or obtain loans from foreign governments. It’s a complicated financial system but the point is: opportunity costs.

Federal opportunity costs are limited more by political consequences than actual budgetary restrictions. For example, imagine if you went to the polls in November to vote on the budget and the questions read as an opportunity cost. You’d have to choose between a border wall, improved infrastructure, larger military, or an to end homelessness.

When the government (or individuals) can borrow money, it negates the value of considering opportunity costs in decision-making.

However, as I mentioned, it can be an overwhelming, even paralyzing, concept in terms of time and money. It can be exhausting to consider that you are spending your money at the “expense” of everything else you could buy or spending your time at the “expense” of everything you could be doing.

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