Opportunity costs are important concepts in economics, and they’re something that we contend with every single day. Whether we realize it or not.
Let’s start with an example: Recently, housing prices have gone through the roof, to use an apt pun. While homes have been expensive in big cities like New York or San Francisco for a long time, cities like Seattle, Denver, and Austin have seen big influxes in population over the past ten or so years, and as such, homes in those cities have become much more expensive.
But now, the homes in those cities are out of reach for many potential homebuyers. As such, people are moving to smaller, more affordable cities, like Boise, Idaho, and Spokane, Washington.
And while someone from San Francisco with a good-paying job could probably afford a home in Boise, if they choose to move there, they’re also giving something up: Ties to the Bay Area, and potential job opportunities in San Francisco. If they can’t work their job remotely, either, it means giving up their high Bay Area salary, and instead, finding a local job in Boise, where salaries aren’t nearly as high.
As such, moving to Boise may be cheaper in some regards (housing), but incur a significant cost in others (career opportunities and salary expectations). There’s a tradeoff.
What are opportunity costs?
The tradeoff exemplified above is an example of an opportunity cost. Opportunity costs are, in their simplest form, the cost of what you choose NOT to do.
So, if you choose to go to the movies and spend $20, the cost of doing so is saving that $20 for something else. Conversely, if you choose not to go to the movies and save the $20, you gave up the opportunity to see a new movie you’d been looking forward to, and having a good time.
Every choice you make incurs an opportunity cost. But the big ones have to do with our career and financial decisions. Choosing not to invest your money can result in you missing out on big market gains – a significant financial opportunity cost, for instance.
Choosing not to go to college may save you money on tuition. But it can cost you the potential earnings a degree may afford you from a better job down the road, or cost you potential connections and friendships.
Opportunity costs come in all shapes and sizes, too, which is what makes them particularly difficult to understand.
Why it’s important to understand opportunity costs
When you learn to recognize opportunity costs, you’ll start seeing them everywhere. But why are they so important when it comes to money? Because by forgoing small expenses now and saving and investing your money instead, it will grow over time.
In other words, by seeing the chance to save money, rather than spend it, as an opportunity to put it to work for you, you could be looking at a big potential return in the future. Of course, the tradeoff is whatever you’re choosing not to do or buy in the present.
Again, go back to our movie example. If you choose not to go to the movies, and instead, buy $20 worth of an S&P 500 index fund, that investment could grow to be much more valuable in the future. The question is this: Would you rather have seen the movie and had a good time (which is perfectly reasonable!), or potentially see a big return on your investment later?
The thing about opportunity costs that’s also important to remember is that there isn’t always a “right” choice. We have to eat, relax, and have a good time – things that cost money. It’s important that you recognize that, and feel okay spending that money. Not every cent needs to be stashed away.
But it is critical to build some saving and investing habits into your budget. Make sure you’re putting money away for the future – and some to have fun right now, too – but don’t forget about your financial goals.
While there is a lot more to be said about opportunity costs – and it’s likely a topic we’ll revisit in the future – getting a grasp on the basics of the concept is critical no matter your age or individual financial situation.
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