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Opportunity Cost: What It Is and How to Account for It
Opportunity Cost in Non-financial Situations
Opportunity cost in non-financial situations is more difficult to quantify. The loss or gain with choosing an option while foregoing another can be subjective and not readily comparable.
Example: While deciding on which job offer to take, we may consider job satisfaction, brand name, commute time, long-term growth, and the salary offered. While finalizing, we have to forego the other best offer. While deciding on a career, we have to consider options like prestige, impact and the work sector.
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Opportunity Cost
It is the estimated value of the best alternative or the best option that one misses out as a consequence of picking one particular option.
Example: Spending a limited resource, like Money, on healthcare, comes with the 'opportunity cost' of being unable to spend that amount on education.
Calculating Opportunity Cost
The way to calculate the opportunity cost is to subtract the value of the option from the value of the alternative that is foregone.
Opportunity Cost = Return on the best foregone alternative - Return on the chosen option.
Importance and Risks
Opportunity cost calculation is essential to individuals, corporations and governments, where there are decisions to be made regarding limited resources like time, money and effort. Choosing one of the scarce resources always leads to a trade-off in gains.
It is important to account for risks associated with the different available options. Often the rewards that different options offer come with a certain risk.
Opportunity Cost Calculations
Many people and organizations fail to take into account the various opportunity costs.
- We need to actively question ourselves about the alternatives that may be missed out by deciding on a particular option.
- The often neglected cost of waiting too long is also a decision that can incur a significant amount of opportunity cost, as we lose the time window to take action, losing the better option due to delay and inaction.
- Not taking an action is also a decision that needs to be evaluated, just like other options.
Overestimating Opportunity Cost
Certain external constraints make us overestimate the opportunity cost, as we start to imagine all the foregone options as a missed opportunity and start to see the situation irrationally. This can cause a negative emotional and psychological reaction, like regret.
The opportunity cost in these cases should not be viewed as the sum of all your skipped alternatives, but only the value of the best one which is foregone.
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The decoy effect
It happens when consumers change their preference between two options when presented with a third option, or decoy.
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How decoys work
When consumers are faced with many alternatives, they often experience choice overload that increases anxiety and hinders decision-making.
Consumers try to reduce this anxiety by selecting only a couple of criteria (say price and quantity) to determine the best value for money.
A decoy steers you in a particular direction while giving you the impression that you are making a rational, informed choice.
Decoy example in the market
Consider the price of drinks at a well-known juice bar: a small (350 ml) size costs $6.10; the medium (450 ml) $7.10; and the large (610 ml) $7.50. The medium is a slightly better value than the small, and the large better still. The medium is designed to be the decoy, steering you to see the biggest drink as the best value for money.
If you buy the biggest, was it because you made a sensible choice, or have you been manipulated to opt for bigger than intended?
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Suggests that holding 2 or more contradictory beliefs at the same time causes people to experience mental discomfort, which manifests as psychological stress.
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The Benjamin Franklin effect has generally been explained using cognitive dissonance theory.
Essentially, this means that when someone does you a favor, they need to be able to justify...
The Benjamin Franklin effect has generally been explained using cognitive dissonance theory.
Essentially, this means that when someone does you a favor, they need to be able to justify it to themself, in order to avoid the cognitive dissonance that might occur from doing something nice for someone that they dislike.
The Benjamin Franklin effect
Is a psychological phenomenon that causes us to like someone more after we do that person a favor: We justify our actions to ourselves, that we did them a favor because we liked them.
But the reverse effect is also true - we come to hate our victims, which helps to explain wartime atrocities.