You’ve probably heard the term “opportunity cost” thrown around a few times in your life. But, what is it really, and does it impact our lives?

Here is a quote from money.aol. com
(money.aol.com/investing/fct1/_a/ opportunity-cost/20050225133509990013):

Opportunity cost is an important economic principle that affects the value of our financial decisions. For example, if we make a $1,000 payment on a 12% credit card, we can lower our interest expense. For one month alone, we save $10 in interest ($1,000*0.12/12). However, in order to pay down this debt, we may have passed up an opportunity to earn a 5% annual interest rate in a CD or other money market account. The opportunity cost, in this case, is $4.17 ($1,000*.05/12) in interest income. Subtracting the opportunity cost of $4.17 from the debt savings of $10, we obtain a net savings of $5.83.

Examples like this are common; however, they are misleading. They are misleading because there is no actual cost of $4.17. The amount saved is, de facto, $10, not $5.83. $5.83 is a phantom net gain.

To say it another way, let’s assume you have two alternative courses of action – two choices – we’ll call them Choice A and Choice B. If you pick Choice A, then you give up the opportunity of Choice B and vis versa.

The theory of opportunity cost would question whether the cost of Choice A equals the “cost” of Choice B and the cost of Choice B equals the cost of Choice A. If both Choice A and B offer the same value, then either choice is fine. But if you chose Choice A and Choice B happens to be more valuable, the theory of opportunity cost will tell you that you’ve lost money because your potential revenues are lower and your costs higher with Choice A. But this isn’t true. “Cost” is only incurred when you take action. Since you never chose Choice B, you never actually incurred any cost. But that doesn’t matter according to the theory of opportunity cost, because the potential cost of Choice B is still treated as an actual cost.

This leads to mistaking the potential for the actual, which is a serious mistake. There is no cost associated with Choice B because you never took that choice. Furthermore, regardless of whether you chose Choice A or Choice B, you benefited either way – you didn’t lose…at all. If the value exceeds the cost, you are better off because of your choice.

A more concrete example would be the question of buying a car with cash (after saving up the money), or just financing it and keeping your cash in the bank or another investment at a higher rate of return. The assumption is that the individual is “losing” by financing the car and “giving up” the higher rate of return elsewhere. Even if the car could be financed at say 4% and the investment could be 6%, there is no actual loss of 2% by paying cash.

This brings us to the concept of efficiency. Opportunity cost deals with treating potential loss as a real loss. However by looking at the efficiency of a particular option, you can get a better grasp of what will produce the highest value for you. Using the above example, you didn’t lose 2%, but perhaps a more efficient method of buying that car would be to finance it and invest the cash.

Efficiency and opportunity cost, while there are similarities, are not the same. When you look to efficiency, you are looking to improve. When looking at opportunity cost, you are attempting to reify a nothing by treating the potential as an actual.

This is especially destructive when the Government applies this theory (of opportunity cost) to taxation of businesses. As a business owner, you can end up paying taxes on income that you never had. As a private investor, you can wind up needlessly worrying about money that you never lost.

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This entry was posted on December 29th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Investing