By Gary Foreman
Sometimes it's helpful to take a concept out of it's original
environment and see how it fits someplace else. Today we're going to examine an
economic theory and see how it might apply to our personal lives.
The Economist website <economist.com> defines 'opportunity cost'
as "The true cost of something is what you give up to get it. This includes not
only the money spent in buying (or doing) the something, but also the economic
benefits that you did without because you bought (or did) that particular
something and thus can no long buy (or do) something else."
To put it simply, for everything you get, you give up something
else. That's an important concept. Let's consider an easy example. If you spend
$15 on a pair of jeans, you do not have that money available to buy a pizza. The
'cost' of the jeans is not only $15. It is also giving up a pizza.
Another way to look at opportunity cost is the amount of time we
give up working to buy a product. Suppose you make $12 per hour. Our tax rates
are all different, but you can pretty much expect to pay about 1/3 in Social
Security and federal, state and local income taxes. That leaves you with $8.
Let's further suppose that you go out to lunch with co-workers
every day. And a typical lunch costs you $6. Add a tip and sales tax and that
lunch brings the total to $7.20. So you give up 54 minutes of your life every
day to work just to pay for lunch.
How about a different situation. Remember that an opportunity
cost is what you give up by making another choice. For instance, suppose that
you choose to spend $100 on a credit card knowing that you'll pay the minimum
when the bill comes due. In effect you've given up about $140 in the future to
make that purchase today. That's because finance charges will be added to the
cost of your purchase.
We face opportunity costs with our time, too. I can choose to
spend an hour watching TV. But that's an hour that I won't be talking to my
wife, playing with the kids, doing home projects or sleeping. Of course,
watching TV might be the best use of that hour. Still, it's a good idea to think
about it before you spend the hour.
Sometimes the difference between choices is surprising. Suppose
you spend $1 at break time five days a week. No big deal. Right? But if you
didn't spend that dollar every day and put it in a bank at 3% interest, you'd
have $3,000 in ten years. Or $7,100 in 20 years. Or $20,000 in 40 years. So by
choosing that $1 snack each day you've given up a new car when you retire. A
good trade- off? Only you can decide.
There's also the possibility of trading money today for time
tomorrow. For instance, you could use the money from those work day snacks to
allow you to retire 3 or 6 months earlier than you would otherwise. Is it
unusual to think of 'banking' a few minutes each day towards an early
retirement? Perhaps, but it does give you a new perspective on spending.
But, what about credit cards? Don't they make it possible to buy
both things that we want? Yes, you can use your plastic to do that.
But credit cards are deceptive. They lead you to believe that
you can spend more than you make. And, for a short time that's probably true.
But eventually you get to a situation where you can only afford the minimum
payment each month. Once there, you're back where choosing to spend on one thing
prevents you from buying something else. And, you've also made the choice of
paying interest to the credit card company on the monthly balance instead of
having that money for other uses.
So how can you use opportunity costs to help you live a happier
life? By thinking of the alternatives before you spend your time and money. Even
though something looks good, if you stop to compare, you might find something
else that you'd prefer to spend your time or money on.
Gary Foreman is a former financial planner who currently edits The Dollar
Stretcher website <www.stretcher.com>
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