Ever feel like you're missing out on something? Well, you are. As American novelist F. Scott Fitzgerald put it: "Our lives are defined by opportunities. Even the ones we miss."
Opportunity Cost is the missed opportunity from the 'path not taken' resulting from any choice.
LOSING THE NEXT BEST ALTERNATIVE.
Opportunity Cost represents the trade-off or loss you incur from not doing the next best alternative to your choice. It is a critical Mental Model in economics, helping to ensure that limited or scarce resources are used to their greatest advantage. That said, this mental model is highly adaptable to a range of domains, particularly when incorporating non-financial costs.
NOT THE WAY WE THINK.
You might believe that this model is obvious and something you use without thinking, but you'd likely be wrong. One study cited by the Heath Brothers in their book Decisive, gave people a choice between buying a video for $14.99 or not, only 25% did not make the purchase. However, when the choice was posed as buying the video or keeping the $14.99 for other purchases, 45% of people did not buy the video. It's an example of how the Opportunity Cost had to be explicitly called out before it impacted decision-making.
CONSIDER OPPORTUNITY COST AS HABIT.
You've likely heard of this model, but are you using it on a regular basis? For any decision you make, or any time you choose not to take action, are weighing your results against the lost opportunity?
When faced with a choice, be sure to ask yourself what the alternative would be and what it would give you. And again, this is relevant for choosing inaction as much as action.
IN YOUR LATTICEWORK.
Opportunity Cost is a key model in decision making, economics and creating efficiencies. It relates strongly to the Regret Minimisation Framework, to help make bold decisions; is used in negotiations as part of BATNA, and can impact consumer choices in the form of the Lock-In Effect and the Paradox of Choice.
Finally, when considering Opportunity Cost, it's tempting to just consider and compare the immediate implications of any two choices. A more effective approach involves combining this model with Second-Order Thinking, to incorporate downstream costs and benefits.
- Ask: ‘what else could I be doing with this time/money and what would that give me?’
Asking this question focuses your attention on the alternative options that you are not selecting, providing an opportunity to rate them against your current choice. Ideally, these would be rated based on your broader goals or values.
- Ask: ‘what’s the cost of doing nothing?’
Inertia means that the opportunity cost of inaction is often ignored. Asking this question can highlight the Opportunity Costs of not taking action.
- Prototype and test
Considering Opportunity Costs is a reminder to test and consider low fidelity prototyping to gain more data on the potential returns from various options available to you.
Opportunity Costs are difficult to calculate, especially when they relate to non-financial considerations. Focusing on Opportunity Costs might also a risk of ‘analysis paralysis’ arising from fear of making the incorrect choice. Finally, assessing Opportunity Costsaccurately is not always practical for every decision, all the time.
Even ‘saving’ has a cost.
Saving money in a bank account with a defined interest rate has an opportunity cost of the lost returns from an alternative venture that you might have invested in.
Benjamin Franklin: ‘Time is money’.
Franklin coined the term ‘time is money’ which can be viewed as another example of opportunity cost. In 1974 he wrote “Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expense; he has really spent or rather thrown away Five Shillings besides.”
What about dinner?
If you are considering buying pizza or asian food for dinner tonight, then finally decide on pizza. The opportunity cost is the asian food that you did not choose.
Opportunity cost is a key mental model in decision making, economics and creating efficiencies.
Use the following examples of connected and complementary models to weave opportunity cost into your broader latticework of mental models. Alternatively, discover your own connections by exploring the category list above.
- Sunk cost fallacy: when considering past decisions and ‘cutting losses’ moving forward.
- Cost-benefit analysis: in deciding on a course of action.
- BATNA: in considering the best alternative.
- Second order thinking: considering the implications beyond the immediate.
- A/B testing: to weigh up potential opportunity costs.
- Regret minimisation framework: a decision process that imagines the long term opportunity cost of inaction.
- TANSTAAFL: linked to ‘There ain't no such thing as a free lunch’ mental model
- Compounding: considering the opportunity cost of small consistent investments over extended periods of time.
- Inversion: considering the cost of doing nothing.
- Blue ocean strategy: considering new areas of exploration rather than highly competitive areas.
Opportunity Costs was first introduced as an economics concept by David L. Green in 1984, in his article: Pain cost and opportunity cost. It appeared in the Quarterly Journal of Economics. Its origin is also linked to TANSTAAFL (There ain’t no such thing as a free lunch) in 19th century America in saloons.
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