Opportunity cost is the value of the best alternative you did not choose. It is the concept economists point to first, because most bad decisions are made by people who counted only the cost of the choice they made and none of the cost of the choice they gave up.
- 01Define opportunity cost precisely.
- 02Distinguish accounting cost from economic cost.
- 03Apply the idea to a real household decision.
Economic tradeoffs
Every choice made under scarcity is a tradeoff. The true cost of taking a job is not the taxes and commute — it is also the second-best job you turned down. The true cost of buying a house is not the mortgage payment — it is also the return the down payment could have earned elsewhere. Economic reasoning insists on counting both.
Scarcity
Opportunity cost exists because time, money, and attention are scarce. In a world without scarcity there would be no opportunity cost, and no economics. Since we live in the other world, every plan must be judged not only against nothing, but against the plan we did not adopt.
Decision making
The discipline is to write down, before a decision, what the alternative would have looked like. Households that do this consistently make measurably better long-run decisions than households that do not. It is not that they are smarter — it is that they are counting the same costs.
The house-versus-index-fund case
A household buys a $500,000 house with $100,000 down. The mortgage payment is $2,500 a month. The accounting cost of ownership is the mortgage, taxes, and maintenance. The economic cost adds the opportunity cost of the $100,000 down payment. At a 7% expected return, that is $7,000 a year — about $580 a month — that must be added to every housing calculation to compare honestly against renting.
- Opportunity cost = value of the best alternative you did not choose.
- Accounting cost ≠ economic cost. Economic cost includes opportunity cost.
- Write down the alternative before you decide, or you will not count it.