Friday, April 3, 2009

Understanding Opportunity Cost

"Time is money."

I'd always heard that growing up, but it wasn't until I took an economics class in college that it really sunk in. It was in that class, that I first learned about opportunity cost.

Opportunity Cost - the value of the next best alternative foregone as the result of making a decision.

Learning about opportunity cost really opened up my eyes. It caused me to evaluate how productive I was being with my time. This made me question the usefulness of any given task I was doing - specifically tasks that were earning me money. Was it worth the time and effort?

For example, I had a little eBay business in college, and I started to wonder whether or not it was a worthwhile endeavor. I calculated the time spent gathering the items to sell, taking pictures of them, uploading the pictures to my computer, writing descriptions of the products, filling out the forms on ebay, checking updates online, sending emails to the winners, packaging the product, going to the post office to send the items, and so on.

After calculating all of these things, I realized I wasn't even making minimum wage. I could have spent the hours I worked on the eBay business working for a neighbor who had offered me $10/ hour. That was my opportunity cost! But I liked doing my eBay business, so I began finding ways to cut down the amount of time I spent in order to make it worthwhile.

Knowing about opportunity cost also made me realize the real costs of going to school or going on unpaid vacation. Here's a scenario for you:

Billy is a waiter at a classy restaurant in Las Vegas. He finds a killer deal on the web, and decides to take off work for one week to go on a ski trip to Colorado during the week of December 29th - January 5th. Although his co-workers tell him that it's going to be really busy that week at the restaurant, Billy tells them that he just can't pass up this deal. He claims he'll never find this good a deal ever again.

Or will he...

Let's crunch the numbers.

Billy found a one week, all-inclusive ski package at a nice hotel for $350 (normally $700).
He also found a roundtrip airline ticket on craigslist from Vegas to Denver for $50 (normally $150).

That's a savings of $450!


On a normal day at the restaurant, Billy earns $20 in wages and $100 in tips. However, since it is the week of New Year's Day, Billy can expect to walk away with nearly double the tips of a regular day. Hence, $220/day will be foregone as opportunity cost.

$350 Hotel-Ski package
$50 flight
$1,540 opportunity cost (wages + tips for one week)

=$1,940 TOTAL

Billy thinks he'll never find a better deal. In reality, all he has to do is go to Colorado during a low time at the restaurant (like mid-March) and pay full price for the package. That way the math will look like this:

$700 Hotel-Ski package
$250 flight
$840 opportunity cost (wages + tips for one week)
=$1,830 TOTAL

So, it's nearly $100 cheaper for him to go at a different time and pay full price for everything. And although he may not get the steal of a deal he found before, he'll likely find a way to avoid paying full price! Plus, if he chooses a low time, his opportunity cost will probably be less as well since he could very well make less than his average of $100/day in tips.

Hopefully this gives you an idea of the power of opportunity cost. Examples really help me to grasp concepts, and this one is as clear as day. Got a comment? Leave it here before you go. I'm out - YCC

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About Me

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I'm just a young guy, working hard (but not too hard) as a full-time teacher. I survived college without accumulating a penny of debt and have a decent nest egg saved up for retirement. Like my father and grandfather before me, I've been raised to earn, save, and spend wisely. I'm always on the look out for bargains, deals, promotions, financial tips and advice, economic news and anything else related to money. My goal is to let you in on everything that has served me well over the years financially, as well as all of my latest money discoveries. Enjoy!
Got a question for me? An idea for a blog entry? Shoot me an email at youngcashcow(at)gmail(dot)com and I'll be sure to respond asap!