What is an opportunity cost?
I’ll explain using an example. If you decide to attend college. The true cost of going to college is much more than your room and board and tuition costs. You should also factor in how much you could earn working a full time job. If you knew for sure that you could earn $30,000 per year working full time. then your decision to attend college should factor in this additional cost.
Why is factoring in your opportunity cost so important?
Well, if you don’t, then you may end up making a lot of not-so-smart decisions simply because you haven’t properly factored in all of the pros and cons when making important decisions.
How can I make a wise decision by factoring in all of my costs rather than just the obvious dollar costs?
The best way to make a wise decision is to consider what you are giving up (so, in the case of going to college, you are giving up $30,000 per year in addition to alternative uses of the money you will spend on obvious costs of going to college) as well as to consider what you will gain (how much more will you be able to earn from your career after you complete college?). If your gains are expected to be greater than your costs, including your hidden opportunity costs (aka the salary you forgo), then it’s a wise idea to attend college. However, if you determine that your earning potential after graduating from college is not going to be greater than your costs to attend college, then it’s likely smarter for you to work rather than attend college.
I used the college illustration as it’s easy to relate to. This concept of weighing the pros and cons by also considering the hidden opportunity costs can and should be applied to all of the major decisions you face. By doing so you can objectively make smart decisions based on all of the facts not just the obvious ones.
By the way, this concept is by no means unique. This is an economists’ way of looking at the world.