In the table below there are four options. You want to invest in one of them. How do you decide?
A dollar can be spent only once. So if you spend it on A it is no longer available to be spent on B or C or D.
Opportunity cost - almost anything you decide to do has a cost
| Option A | Option B | Option C | Option D |
|---|---|---|---|
| Spend a dollar on A. | Spend a dollar on B. | Spend a dollar on C. | Spend a dollar on D. |
| You will get the benefits that option A provides (financial or otherwise). | You will get the benefits that option B provides (financial or otherwise). | You will get the benefits that option C provides (financial or otherwise). | You will get the benefits that option D provides (financial or otherwise). |
Commentary on Opportunity cost
Find the alternatives
To make an informed decision, list the alternatives available for consideration.
There are usually different opportunities or methods available to accomplish a desired outcome.
Alternatives
If you are making an investment for a return, then there will usually be several strategies that can be considered. They will often give different returns (and have different risks).
Evaluate the alternatives
Work out the benefits of each alternative.
The benefits may be financial or non-financial. These should be quantified so that a reasonable comparison can be made of the alternatives.
Evaluate
For a financial goal, the return is a key factor in making the decision. If you invest in a very high return investment, usually the risks will be higher. The opportunity cost is clear – one investment provides a high return, but there is an associated big risk. The second investment pays a lower return, but also has a lower risk.
Opportunity cost requires you to weigh up the benefits of both. If you choose one, you loose the opportunity to invest in the other.
Decide
After completing the analysis, you should be in a position to be able to make an informed decision.
Keep in mind that if you choose A, the opportunity cost is that you can no longer choose B or C or D.
Decision
Several factors will influence your decision, including the financial return and the possible erosion of the capital invested (due to the risk factors).
Of course, sometimes the benefits are non-financial (e.g. spend money on schools or roads or hospitals). The concept of opportunity cost still applies.
Benefits and limitations of Opportunity cost analysis.
There are few limitations – almost all decisions take into account an assessment of the opportunity cost, even if you do not do so consciously.
Decision making can be improved by a rigorous assessment of the opportunity costs of any decisions.
It re-enforces the concept of alternatives – most decisions will benefit by an opportunity cost analysis.
Opportunity costs analysis is recommended for informed decision making.