Core Principle 2 - The Opportunity Cost Principle - Or What?

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It's time to think like an economist.
Thinking like an economist is why I don't eat donuts
even when they're free on the morning meeting platter?
What do donuts have to do with thinking like an economist?
More than you think? I mean, I'm trying not to
overdo the junk food, and so if I have a
donut the morning meeting, I won't have a bowl of
ice cream after dinner. To give you the full economists speak,
the opportunity cost to me of eating a the owner
in the morning is a bowl of ice cream after dinner.
And because I think like an economist, I choose to
forego the donut so I can eat the ice cream.
But justin you can have both.
Actually I can't if I care about my heart and
my waistline.
Welcome to think like an economist with me, Betsy Stevenson.
And I'm justin Wolpher's. We're going to teach you how
to make better decisions throughout your life, be it buying
your car, choosing your career, or knowing if you should
eat that extra donut.
We're going to speak to people running small businesses and
central banks, and to the different generations of a family
to teach us how to think like an economist because
it will transform your life. Journalist and former economic student
Nastaran ta Akoli far joins us.
Hi Betsy Hi, justin, we're going through the full core principles,
which you say underlie almost all decisions that we will make.
So last episode we looked at the course benefit principle.
What are we going to look at today?
We're moving on to the opportunity cost principle. We define
it this way. The true cost of something is the
next best alternative you must give up to get it.
So let me give an example. In many cases, the
most important opportunity cost of going to university is having
a full time job. That's because most university courses require
enough of your time and attention that it's going to
be impossible to hold both a full time job and
to be going to university at the same time. Sure,
there are people who do juggle both, but that comes
to the different set of opportunity costs like giving up sleep, exercise,
or time for friends and family.
So you're talking about the next best alternative exactly.
Now, this is important to us, as in our last
episode we went through the cost benefit principle. The thing is,
when we make decisions, we need to look at the
full set of costs that a decision involves. The full
set means not just the out of pocket or the
financial cost that we can count in dollars.
Yeah, the opportunity cost principle really gets us to think
about alternative uses for our time and our money. It
makes us look at the consequences of our choices and
to think about alternative uses for our time and money,
or rather to consider the trade offs of our decisions.
Opportunity costs are so fundamental decision making that often when
we economists talk about costs, we're talking about opportunity costs.
Okay, So basically we're broadening the meaning of costs to
not just refer to the money we pay for something,
but also anything else we might give up.
Yes, and let's go through some examples so we can
really grasp this. So, Naz, say you want to study
an extra hour of economics after work, because you're learning
how to think like an economist, so this doesn't cost
you anything out of pocket, but your time is scarce,
and an hour after work studying economics is an hour
you can't spend studying something else, say learning the piano
or catching up with a friend, and those things can
be equally important for you as an extra hour of economics.
You should only spend an extra hour studying economics if
the benefits are at least as large as that next
best alternative.
I think this really hits on a key point, which
is that time and resources are scarce, and that's what
the opportunity cost principle highlights. Whenever you choose to do something,
you're implicitly choosing not to do something else. So let's
make it explicit. We don't just have limited money, We
also only have twenty four hours in a day. If
you're like me, you have limited attention maybe limited willpower.
The scarcity of these resources imply that you'll always face
a trade off when you're making decisions.
So wait, this sounds like that famous poem The Roads
are not taken Exactly two roads diverged in a wood,
and I took the one less traveled by, and that
has made all the difference.
Robert Frost got it. The road not taken is the
opportunity cost. It's the next best alternative for Frost's character.
So you see, economics really is poetry.
So with the cost benefit principle, we basically looked at
how much we were willing to pay for something so
that we could figure out the benefits. So what do
we do when we're trying to factor in the opportunity
cost of something?
So the opportunity cost of something is what you give
up to get this thing. So you need to ask
yourself two questions. Question number one is what happens if
you pursue your choice? And question number two is what
happens under your next best alternative.
Okay, so let's look at a case study so we
can really dig in.
Hi, I'm Milana. I'm going to be starting an NBA
this far.
Alana. She's been working for a nonprofit in China for
a few years and she recently moved back to the
US because she's preparing for her upcoming NBA.
Three years ago, I decided that I wanted to pursue
an MBA because it's one of the easiest ways to
drastically increase and I also wanted to diversify my employability
and the types of sectors that I could work in
and the kind of work that I could do.
What is it that you want to get out of
your work? What's the main motivation that you have for you?
I'm looking for more opportunities and for stability.
How much is your tuition for your MBA?
My MBA program is two years. For the first year,
the tuition is about fifty one K US dollars and
I will be paying fifteen k USD.
The tuition's fifty one K. You'll be paying fifteen K.
Where is the rest of the money coming from?
I was fortunate enough to receive two merit based scholarships
from my school as a part of my admissions offer.
Congratulations, Thank you. Do you know how much you'll be
paying for room board, living expenses?
I've asked meated that I'm going to be paying thirty
two to thirty five thousand US dollars a year in
living expenses.
Let's quickly stop and do some calculations.
So the first thing we need to look at is
the cost of her choice to pursue an MBA. You
might think the big expense is tuition. So she's going
to be paying fifteen thousand dollars a year because she's
smart and she's got some scholarships to cover the rest.
She'll be spending up to thirty five thousand dollars a
year on living expenses. Now we need to look at
the cost of her next best alternative, which is to
stay in her job.
The last year I worked, I made thirty nine thousand
dollars after tax I paid somewhere between six hundred and
eight hundred and rent, probably a similar amount on food
each month. I had a few other expenses that brought
things to about twenty five thousand dollars that year.
And what did you do with the rest of the money?
I put the rest of the money into a savings account.
Since her next best alternative to go into graduate schools
to stay in her job, she'll be foregoing that salary
she was earning that thirty nine thousand dollars in income.
She said, she's twenty five thousand dollars this past year
on living expenses.
So how do we calculate her opportunity costs? And let's
just do this for one year. And see what we get.
Okay, so she'll be paying fifteen thousand dollars in tuition.
We're going to add to that what she won't be
earning from her job, which is thirty nine thousand dollars
in four gone income. That gives us a total of
fifty four thousand dollars.
Now, let's look at her living expenses. This past year,
she spent twenty five thousand dollars on living expenses, but
she estimates she'll spend as much as thirty five thousand
dollars on living expenses during her MBA. This is an
extra ten thousand dollars she'll be spending. Adding this to
the fifty four thousand we just calculated gives us sixty
four thousand. So her total opportunity cost for doing an
MBA for a year is sixty four thousand dollars plus
any kind of incidental one off cost that she thinks
she might face as she transitions to graduate school.
And how about her time, Because we keep talking about
the importance of time I'm in this episode about opportunity costs,
how does that factor hit.
Well, she's sleeping full time employment to study full time.
So these cancel each other out either way, she'll be
working pretty much full time. She's just swapping a desk
at her job for a desk at her school.
And so is it worth doing the NBA given this,
I mean, sixty four thousand dollars is a lot of money.
Well, this depends on how valuable the NBA will be
in achieving her goals. And realize everyone may have a
different goal for going to school. It isn't always just
about boosting your income. It could be the joy of
learning or other factors like just pursuing the passions that
you face in life. Let's hear what she says.
I really want to take this time to understand where
the market is going and what's going to be most important,
not just two years from now, but ten or fifteen
years from now, because I really wish when I did
my undergraduate degree that I had looken at the market
and where the most employment opportun news we're going to.
Be and how much would you like to earn after
your MBA.
As much as possible. My school is like a ninety
nine percent job placement rate within three months of graduation,
and the average starting salary is about one hundred and
twenty K and.
The average starting salary of one hundred and twenty and
a ninety nine percent job placement rate after three months
of graduation. That sounds pretty good for someone who wants
more stability and better job opportunities. It sounds like an
MBA is going to be the right decision for her.
A good trick to make sure you're applying the opportunity
costs principle is to make sure that the word or
is in the middle of your sentence whenever you make
a decision. For instance, don't just ask should I get
an MBA? Ask should I get an MBA? Or should
I continue working full time? And you can often list
more than one alternative. Now as let's have a crack
at this, what does the opportunity costs to some of
the following decisions? Should you hire your best mate to
work for you?
Oh, should you hire someone else? Or should you put
up a posting on a message board?
And so the opportunity cost is the best of those alternatives.
Let's try it again. Should you spend all of your income.
Or should you save some of it to think about
spending later? Like we can make these more complex too.
Should you save that money in the bank.
Or should you put your money into stocks?
Yes, And the full decision is actually this, should you
save your money in the bank where it will be safe,
but the value of your savings won't rise by very much?
And on your side.
Nas okay, so I said, or should you put them
into stocks? I guess where your money may increase in value,
but it might also lose value. So basically, you're deciding
about how much risk you're willing to take exactly.
And this is the thing to remember. The answers to
these questions are unique to you, So when you think
like an economist, you'll be applying the tools of economics
to make decisions about your who are unique life.
Is there anything we need to be careful about but
can sway our decision making the wrong way.
It's a really interesting implication of the opportunity cost principle,
and it's all about sunk costs.
Sunk costs refer to the money you have spent that
you can't get back. And here's where the opportunity cost
principle offers you concrete advice. You need to ignore sunk costs.
It's so important that I'm going to say it again,
ignore sunk costs.
Unfortunately, instead of ignoring somenk costs. People ignore the advice
to ignore somek costs. They do it all the time. Look,
you'll recognize it in yourself if you can remember the
times where you dwelt on all the time and money
you've already spent on a project. I've got some friends
who'd run a cafe for a few years. They've invested
tens of thousands of dollars and thousands of hours doing
marketing and spreading the word, and it just wasn't working.
But their reaction was, we can't leave now. If you
find yourself in their position, remember one big idea. You
can leave it, and all the time and money you've
spent say on that cafe are irrelevant right now. You'll
never get it back. You really need to ask about now,
what is the best choice to make now?
So a bit like let bygones be bygones and focus
on the future.
Yes, sunk costs aren't opportunity costs. You've sunk all that
money and all that effort. When you ask all what
you realize that those sunk costs are irrelevant to your
future decisions. If you haven't really practiced thinking like an economist,
you might find it hard to ignore sunk costs when
you're making decisions, but you really need to.
Yeah, So I feel like we see sunk costs all
the time. You know, people stay in bad relationships because
they've been together for years. Or people will train to
be a lawyer or some other profession where they need
to do a lot of training and you know they've
done all the work on the degree. They might hate
the job, but they keep doing it because they've spent
all that time getting trained up.
Yes, channel, you're in or Elsa. Let it go. Once
you learn about sunk costs, you'll be so liberated you'll
make better decisions about the present and the future.
So we're going to go through a few more examples
to really get it. You'll see how significant opportunity costs
are and explaining our decisions.
So you know, when you go into a work meeting
and there are free donuts and pastries and.
Things, yeah, usually if it's a morning meeting, as an
incentive for people to turn up.
Right, So I never eat those donuts even though they're free,
And that's because I'm an ice cream fan.
But justin you can eat both.
I could, but I also want to be pretty healthy.
And I want to limit the amount of sugar eat
every day, so to have a reasonable sugar intake, I
can either eat a donut or a bowl of ice
cream after dinner. I love my arter dinner bowl of
ice cream, so the donut goes.
So the opportunity cost of eating the donut in the
morning meeting would be for going your ball of ice
cream after dinner.
Yes, even though the doughnut's free, it comes at too
high of a cost.
Did you know a recession is good news for Netflix?
Their revenues often boom.
I didn't know this, but let me have a stab
at this. So I'm thinking recession you might have lost
your job, so you've got more time to watch things.
Exactly, The cost of Netflix isn't just the price of
the streaming service, but it's the time you spend actually
watching things on Netflix. You could be working and making
money instead of watching TV. But when the economy is struggling,
there are fewer jobs, which means less work to do,
so the opportunity cost of your time is lower. And
this is why the streaming industry actually does really well
when the economy is struggling.
We've just learned about the opportunity cost principle.
Let's summarize the opportunity cost is is whatever you're giving
up to do the thing you want to do. Think
about your next best alternative, What would you do instead
of what you're about to do? And how much is
that alternative worth to you?
If you want to make sure that you're using this
principle all the time, always be asking or what. That's
what the principle's all about.
Is there anything we can practice to really get to
grips with the opportunity cost principle?
As you go about your life over the next few days,
practice asking yourself or what for all the decisions that
you're making, so you really start to identify what those
alternatives are that you're giving up.
And as you practice getting in the habit of always
asking all what, see whether it helps you identify costs
or benefits that you might otherwise have overlooked.
And so what are we going to be looking into
on the next episode.
Next we're going to turn to the marginal principle and
we're going to teach you how to think on the margin.
Cool, okay, so we'll speak to you all next time.
Great talking to you today. I'm Betsy Stevenson and I'm
just a Wolfers and this is our podcast, Think like
an Economist. To get the most out of this show,
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