Overview

There is no such thing as a free lunch. Even if someone buys it for you, you paid for it with your time. Opportunity Cost is the value of the thing you didn’t choose. It is the fundamental concept of economics because resources (time, money) are scarce.

Core Idea

The core idea is Trade-offs. To get X, you must give up Y. The cost of X is Y.

Formal Definition

The loss of potential gain from other alternatives when one alternative is chosen. Formula: Opportunity Cost = Return on Best Forgone Option - Return on Chosen Option.

Intuition

  • College: What is the cost of college?
    • Tuition: $20,000.
    • Books: $1,000.
    • Opportunity Cost: The $40,000 salary you didn’t earn because you were studying instead of working.
    • Total Cost: $61,000.

Examples

  • War: Eisenhower said: “Every gun that is made signifies, in the final sense, a theft from those who hunger and are not fed.” The cost of a bomber is 30 schools.
  • Investing: If you keep $10,000 under your mattress, the cost is the $500 interest you could have earned in the stock market.

Common Misconceptions

  • Sunk Cost Fallacy: “I already spent $100 on this ticket, so I have to go to the concert even though I’m sick.” No. The money is gone. The choice now is: Go (and be miserable) or Stay Home (and rest). Opportunity cost says stay home.
  • Scarcity: The reason opportunity cost exists. If we had infinite time and money, we could do everything.
  • TANSTAAFL: “There Ain’t No Such Thing As A Free Lunch.”

Applications

  • Decision Making: Whenever you make a choice, ask: “What am I giving up?” It clarifies your priorities.

Criticism / Limitations

  • Psychology: Humans are bad at calculating this. We overvalue what we have (Loss Aversion) and undervalue what we could have.

Further Reading

  • Bastiat, Frédéric. That Which is Seen, and That Which is Not Seen. (The broken window fallacy).