Aug 3, 2017
How Does Opportunity Cost Affect Decision Making
We make decisions every day that involve opportunity costs. Often in life, our decisions are mutually exclusive, meaning it simply is not possible to have two things at once. When this is the case, there is an opportunity cost of the thing we did not chose. For example, we can either go out to eat pizza or out for a steak. Rarely would we opt for both at the same time. If we choose one thing, then there is an opportunity cost for not taking the other thing. If we chose to go for pizza because we want it more, then this means the opportunity cost of not having steak is lower than it is for pizza. We can equally say that the opportunity cost of not eating pizza is higher than the opportunity cost of not eating steak, so we chose pizza instead (assuming the monetary cost for both are the same).
This is equally important when making investment decisions. An investor will need to carefully consider what potential investment return is being sacrificed by choosing to invest in something else. For example, an investor may choose to invest in a growth Exchange Traded Fund (ETF) instead of a dividend paying ETF. Before investing in the growth ETF, however, the investor should carefully consider what is being sacrificed by not investing in the dividend paying ETF.
Dividends are a regular flow of cash and contribute to an investment’s total return. If the growth stock doesn’t perform as expected, then the investor would probably have been better off with by investing in the dividend paying investment. Another factor to consider is if the investor has some kind of liability that needs to be paid. If a regular cash flow is required to service a payment obligation, perhaps investing in the growth stock presents too much risk that the obligation will not be met. Considering what is being sacrificed is important before deciding where to put your money.
Considering opportunity costs are also important when making business decisions. Companies are also faced with different investment opportunities. For example, big U.S. automotive manufacturers often face the choice of where to open a new plant, at home or abroad for example.
Let’s say an auto manufacturer is looking to open a new production plant. If they open a new plant in Texas, this presents one set of benefits. If they open a plant in Mexico, this presents another set of benefits. Whichever location they did not chose involves opportunity costs. Opening the plant in the Texas may mean no import tariffs and lower transportation cost on the assembled autos, but possibly higher labor costs.
Opening a plant in Mexico may mean lower labor costs but possibly higher shipping costs. Most business like the auto manufacturer will take these opportunity costs into account when making this investment decision. It is important to remember, however, that opportunity costs are only calculated by looking at the next best alternative, no matter how many other choices there may be and how many factors go into these big business decisions.
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