From choosing your clothes to selecting your investment portfolio is all about choices and how to take them. The society we are living in, has created a world with plenty of opportunities, sometimes more than we can process or assess. Every single day we face different challenges selecting between many options, picking one and rejecting the others.
That innocent and instinctive process hides one of the most powerful economic concept, “The opportunity cost”. Based on it, we can develop different economic model and research about different disciplines focusing on how economic individuals allocate resources based on the preferences, satisfaction or the different economic units.
Let me find the definition → Opportunity Cost → “Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up”. (Investopedia)
It has even its mathematical formula →
Opportunity Cost = Return of Most Lucrative Option – Return of Chosen Option
That simple formula is the core of many other theories that describe how different economic agents take decisions, either in personal or professional life. Game theory disciplines have opportunity cost as core of their model. Prisoner dilemma, Nash bargaining game or Cournot model develop its theories with that simple economic concept in mind. At the end of the day, it is all about maximizing the surplus. It will depend on the economic agent category which surplus will be maximized.
Keep in mind that it is always about the max. opportunity cost → maximize the gap between what you pick and what you reject, no matter if you measure that gap in monetary or satisfaction units. Moreover, to make things worse we have to consider the “Law of Diminishing Marginal Returns” but more about that in another post.
By now let’s keep in mind that opportunity cost is the difference between the option you pick and the one you reject. The second point to consider is that we assess and measure the opportunity cost in every single choice we take.
Considering that we take decisions from the moment we wake up until the moment we go to the bed, it makes sense to try to understand why it is so important to make the right choices and to know what are they based on. At the end of the day it will help us the rest of our life.
The main consequence and point to think of is our ability to assess and value every single situation. Based on that assessment your will pick that one that you value the most regardless how you measure that pair of options. Once we understand that simple concept, what really makes the difference will be the “Law of Diminishing Marginal Returns” leading immediately to a situation where the opportunity cost becomes into a flow variable rather than a static one.
Because “Law of Diminishing Marginal Returns” takes place running any process with recurrent choice picking, it is crucial while negotiating, allocating or rejecting options.