Making sense of 'opportunity cost'

Economics gets its fair share of ribbing, including snark along the lines of "if you're so smart why aren't you rich"? Yet economic concepts can help with financial decisions.

Economic reasoning does well at weighing the costs and benefits of trade-offs, and at making explicit the values in alternative choices. I thought about economics and personal finance while looking at "Campus Economics: How Economic Thinking Can Help Improve College and University Decisions" by Sandy Baum and Michael McPherson. The audience for these two higher-education economists is staff and leaders at colleges and universities. Yet their discussion of one concept stood out as useful for anyone facing a difficult financial decision: Opportunity cost.

Economists call the value of the goods and services sacrificed in making a choice an "opportunity cost." The concept is an imprecise measure for considering the alternatives and landing on the best option under the circumstances. "The opportunity cost of a purchase or a decision is the value of the best foregone opportunity," they write. "If you decide to go to the movies, the cost is not just the ticket price, but also the benefit you give up by not going to bed early and getting extra sleep or using the time to finish the book you have been reading."

Take the decision whether college is worth the cost. There are two parts to college costs. First are the expenses associated with enrollment, such as tuition, fees, and books. (Room and board aren't included since you would pay for those no matter what.) Then there is the opportunity cost of not earning money while in school. The opportunity cost in lost wages for a four-year undergraduate degree was $120,000 in 2019, calculate economists from the Federal Reserve Bank of New York.

The Fed economists find college is worth the price considering the average 14% rate of return on investment, assuming the degree is earned in four years. They add that the return may be much lower in a number of cases, like not graduating in four years. As Charlie Munger, Warren Buffett's legendary investment partner put it, "It's your alternatives that matter. That's how we make all of our decisions." The concept of opportunity costs helps us focus on the alternatives in time and money.

Chris Farrell is a senior economics contributor, Marketplace and Minnesota Public Radio.