Opportunity cost

November 4th, 2008

Quick economics lesson on “opportunity cost.” This is quite possibly the most important, and most practical economic concept to understand. If you can grasp this and plan your life with it, you’re 80% of the way to understanding economics. And possibly have a more fulfilling life.

Opportunity cost is: what you give up to get something else. Every single thing we all have access to is limited: your time and money are the most important and the greatest limiting factors, but distance and accessible space are also important and very constrained. So you have to decide what to give up in order to do the things you need and want.

Time is the ultimate limited resource. You only have 24 hours in a day, seven days in a week, 365 days in a year, and then one day you’ll die. You need to sleep, so there’s 6-8 hours every day that’s given up – but you can sleep less to get more time in the day. But is it worth it? Also, you can have more money than anyone else, but you’re still constrained by how much time you have. Time can be spent, but it can’t be saved.

In exchange for working 40 hours a week, you get money from your employer – so you gave up your time to get money. That money can then be given up for other things like rent, utilities, groceries, drinking, etc. But you have to decide what’s important – do you save for a long-wanted vacation in Europe, or do you go to the bars every night?

Opportunity cost doesn’t just affect how you live your life, it also affects everything else. If we let the government spend its resources on bailing out large corporations and people with bad mortgages, that means less for responsible businesses and citizens who were smart and didn’t overextend themselves. A teacher must choose to spend time helping a single struggling student, or to teach the entire class and help more people who need less specific help.

This is a very simple concept and very logical, but most of the time there isn’t any overt warning signs that we’re allocating our resources incorrectly. That means it’s important to analyze the opportunity cost in every decision we make – OK, that’s hard to do and not always practical (or fun), but at least the most important decisions. My suggestion is to first figure out what you really want in life and what you can give up, and second analyze any decisions you make in whatever you do to earn money. Notice I didn’t say ‘job’ – because earning money is one of the most time-consuming activities, a good use of that time should be doing something that you enjoy and are happy to be doing.

So, what are you going to give up?

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