Opportunity Cost

Opportunity Cost: "The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action."
Investopedia

Opportunity cost is something that we all implicitly understand starting at an early age. If I had a quarter, I could buy a comic book and a Coke (really I’m that old), but I could not buy a comic book, a Coke, and a package of Hostess Twinkies. In such an instance, I would always go for the comic book. The difference in perceived opportunity cost between the Coke and the snack would generally favor the snack. If it was hot enough outside, I might go for the Coke. If there were a good war movie at the local theater, my buddies and I might forego all of the aforementioned options to watch someone shot or something blown up by a team of brave Americans led by John Wayne.

Yes, I remember when Saturday matinees cost a quarter. When I was older, I reflected on how this inexpensive gift of privacy to our parents might have contributed to the size of our generation. Let’s save that line of reasoning for another day, but do consider the opportunity cost involved in that particular transaction.

As we grow older, we make more complex decisions with more long term consequences. In a brief blog post entitled “Making Big Decisions About Money,” Seth Godin explores how our minds work. This is usually to the advantage of the marketer. His first example, “Do I buy a $500 stereo option on a new $30,000 car?” Personally, if I am spending that kind of money on a new car, it will have a good stereo. I would never consider the $500 option. But I remember when my neighbor’s kid had a $3,000 stereo in a $1,000 car. I could hear it through the walls of my house over the noise of a box fan at 3:00 in the morning. Our perception of the opportunity cost associated with car stereo equipment was radically different. Who was right? It all depends on the perceived opportunity cost.

In a rather fanciful and unrealistic thought experiment, Seth then considers the opportunity cost involved in higher education. Consider, you are 18 years old. You have $200,000 in cash. You can choose to expend the entire sum on an education at a famous school or you can go to a slightly less well recognized university on a full scholarship. Let’s say you pay for an engineering degree from MIT or go for free to Penn State. Seth observes, “If you go to the free school, you can drive there in a brand new Mini convertible, and every summer you can spend $25,000 on a top-of-the-line internship/experience, and you can create a jazz series and pay your favorite musicians to come to campus to play for you and your fifty coolest friends, and you can have Herbie Hancock give you piano lessons and you can still have enough money left over to live without debt for a year after you graduate while you look for the perfect gig.”

What are the opportunity costs associated with this example?

In fact the choice of a college degree is often the first decision made by a young adult that will have long term consequences for both the student and the parents. Most parents will fund as much of their children’s education as possible. Generally this comes at the expense of funding their own retirement. This is not a good idea. There are no retirement loans. Neither the parent nor the child will want the monetary burden of old age to fall on the younger generation.

Unfortunately, often neither parents nor child has $200,000 for a college education. Then the opportunity cost of education loans becomes a factor. $200,000 at 5% for 20 years works out to a monthly payment of $1,319.91. That cost is way too high for any education. An education under such terms postpones marriage; it means no children; no house; no life. In short it guarantees the recipient 20 years of debt slavery with no guarantee of a job.

Ultimately, as Seth observes we are not comparing dreams to abstract numbers (the dream of driving down the Interstate with a $500 deluxe stereo booming in our ears with the abstraction of $500 added to a 5 year car note). We are comparing dreams to dreams. Or sometimes we are comparing dreams to nightmares.

And please! Let’s be careful out there.