Opportunity Cost & Costs Benefits Analysis, A Model to MAXIMIZE GAINS & Decide Better from NOW on

Summary

This explainer video introduces the concept of Opportunity Cost, also known as Alternative Cost. It explains that Opportunity Cost is the value of the best alternative not chosen when making a decision. The video highlights how Opportunity Cost is crucial for rational decision-making, touching on both explicit and implicit costs. It also introduces the Costs/Benefits Analysis as a tool for evaluating complex choices. The video concludes by encouraging viewers to consider Opportunity Costs in their decisions and to share the video if they found it valuable.

Takeaways

• 💡 Opportunity Cost, also known as Alternative Cost, refers to the value of the next best alternative that is not chosen.
• 📚 The concept is rooted in microeconomics, dealing with the trade-offs we face when making decisions.
• 📊 The formula for Opportunity Cost is: Opportunity Cost = Cost of Chosen Alternative - Cost of the Next Best Alternative.
• 📖 Dictionary.com defines Opportunity Cost as the money or benefits lost when pursuing a particular action over another mutually exclusive alternative.
• ⏳ The concept was first mentioned in 1894 but can be traced back to Benjamin Franklin’s idea of 'Time is Money' from 1748.
• 💵 Opportunity Costs can be explicit (clearly stated costs) or implicit (implied by the choice of resources).
• ⚖️ Costs / Benefits Analysis is a related decision-making tool where all costs and benefits are listed and compared.
• 🏠 In an example scenario, Bob weighs the opportunity cost of buying a house against leaving money in the bank and earning interest.
• 💭 Implicit opportunity costs include potential benefits, like renting out a house, which may not be immediately obvious.
• 📈 Complex situations may require a broader approach, considering both numerical and non-numerical factors like emotional costs or inconvenience.

Q & A

What is Opportunity Cost?

Opportunity Cost is the money or other benefits lost when pursuing a particular course of action instead of a mutually-exclusive alternative. It represents the value of the best alternative opportunity that is not chosen.

How is Opportunity Cost calculated?

The formula for calculating Opportunity Cost is: Opportunity Cost = Cost of Chosen Alternative - the Cost of the Next Best Alternative.

What is the significance of Opportunity Cost in decision-making?

Opportunity Cost is significant in decision-making as it helps individuals and businesses to consider the value of alternatives forgone when making a choice, thereby promoting more informed and rational decisions.

Who first mentioned the term 'Opportunity Cost'?

The term 'Opportunity Cost' was first mentioned in 1894 by David L. Green in the Quarterly Journal of Economics.

What did Benjamin Franklin famously say about time that relates to Opportunity Cost?

Benjamin Franklin famously stated that 'Time is Money', which is an early concept of Opportunity Cost, implying that the time spent or wasted has an implicit cost.

What are the two types of Opportunity Costs mentioned in the script?

The two types of Opportunity Costs are Explicit and Implicit. Explicit Opportunity Costs have clearly stated costs and benefits, while Implicit Opportunity Costs are not reflected in cash outflows but are implied by resource allocation choices.

How does Costs/Benefits Analysis relate to Opportunity Cost?

Costs/Benefits Analysis is a related model where all costs and benefits of a decision are listed and compared to make a rational choice. It complements Opportunity Cost by considering multiple dimensions of a decision.

What is an example of an explicit Opportunity Cost given in the script?

An explicit Opportunity Cost example is when Bob decides to buy a house for $10,000, he misses out on $500 in interest he would have earned if he had left the money in his bank account.

What is an example of an implicit Opportunity Cost mentioned in the script?

An implicit Opportunity Cost example is the potential income Bob could have earned by renting out his second house instead of using it only for himself.

Why might the formula for calculating Opportunity Cost not be simple?

The formula for calculating Opportunity Cost might not be simple because it can involve non-numerical dimensions such as emotional costs or inconvenience, which are harder to quantify.

How can considering Opportunity Cost help in complex decision-making?

Considering Opportunity Cost in complex decision-making helps by providing a framework to evaluate the trade-offs of choosing one option over another, even when the costs and benefits are multi-dimensional and not easily quantifiable.

Outlines

00:00

💡 Understanding Opportunity Cost: Definition and Importance

This paragraph introduces the concept of Opportunity Cost, also known as Alternative Cost. It provides a basic definition, explaining it as the value of the best alternative forgone when a particular option is chosen. The paragraph emphasizes the importance of choosing options with favorable opportunity costs and highlights that Opportunity Cost is a core concept in microeconomics, closely related to scarcity and choice. A brief mention of the formula for calculating Opportunity Cost is also made, laying the foundation for further exploration.

05:04

📜 Historical Origins of Opportunity Cost

The origins of the term 'Opportunity Cost' are traced back to 1894 when it was first mentioned by David L. Green in the Quarterly Journal of Economics. However, the idea itself had been articulated earlier by thinkers like Benjamin Franklin, who famously equated time with money in his 1748 advice to a young tradesman. Franklin’s quote exemplifies the idea of lost opportunities, and the paragraph highlights how the concept has evolved, becoming more formalized in economic theory over time.

💰 Types of Opportunity Costs: Explicit vs. Implicit

This section explains the distinction between explicit and implicit opportunity costs. Explicit costs are those that can be clearly quantified, often in monetary terms, whereas implicit costs refer to the value of opportunities that are not immediately obvious or measurable in cash outflows. The paragraph also touches on the relevance of considering the benefits alongside costs when evaluating different choices. This sets up a transition to the related model of Costs / Benefits Analysis, which helps in making more informed decisions.

📝 Costs / Benefits Analysis: A Broader Decision-Making Tool

Here, the concept of Costs / Benefits Analysis is introduced. This model involves listing all costs and benefits associated with a particular decision, allowing for a comparison to determine the most rational choice. This approach can be especially useful in complex scenarios where not all costs and benefits are easily quantifiable. By comparing multiple dimensions—beyond just financial factors—the analysis helps in making well-rounded decisions. This analysis ties back to the concept of Opportunity Cost by offering a broader framework for decision-making.

🏡 Example: Opportunity Cost in Action (Bob and Mary)

An illustrative example is provided to show how Opportunity Cost works in practice. Bob, a doctor, considers buying a house from Mary, a realtor, for $10,000. Bob calculates his Opportunity Cost by factoring in the $500 interest he would forgo if he used his savings to buy the house. This shows how Opportunity Cost includes not only the price of an option but also the potential benefits of alternatives. Bob decides to buy the house, and later realizes additional implicit opportunity costs, like the potential income from renting the house, further illustrating the concept.

🏠 Implicit Costs and Multi-Dimensional Decision-Making

The example continues with Bob considering the implicit opportunity costs of not renting out his second house. This section emphasizes how decisions often have multiple dimensions, such as financial, emotional, and practical factors, which may not be easily quantifiable. The paragraph suggests that for complex situations, using a Costs / Benefits Analysis is a helpful approach to capture the full spectrum of opportunity costs and to make better-informed decisions.

🔄 Recap: Key Takeaways on Opportunity Cost and Decision-Making

The final section summarizes the key points covered in the video. It reinforces the definition of Opportunity Cost as the benefits lost when choosing one option over another. The importance of considering both explicit and implicit costs is reiterated, as well as the usefulness of Costs / Benefits Analysis for complex decisions. Viewers are encouraged to share the video if they found the content helpful and are reminded to subscribe for more educational videos in the future.

Keywords

💡Opportunity Cost

Opportunity Cost refers to the value of the best alternative that is forgone when a particular decision is made. The video explains that all choices have an opportunity cost, which is the benefit lost by not choosing the next best alternative. For example, Bob's decision to buy a house leads to missing out on earning $500 in interest, which is his opportunity cost.

💡Alternative Cost

Alternative Cost is another term for Opportunity Cost, emphasizing the loss incurred from not choosing the next best alternative. The video uses the term interchangeably with Opportunity Cost, illustrating how each decision has an alternative that could have been more beneficial, such as Bob choosing between buying a house and earning interest.

💡Scarcity

Scarcity is the economic principle that resources are limited, forcing people to make choices between competing alternatives. The video relates this concept to Opportunity Cost, as the scarcity of resources—like time or money—requires individuals to evaluate the cost of forgoing one option for another.

💡Explicit Opportunity Cost

Explicit Opportunity Cost includes costs that are directly associated with a decision, such as the outflow of cash. In the video, Bob’s explicit cost is the $10,000 he uses to buy a house, as well as the $500 in interest he could have earned if he had left the money in his bank account.

💡Implicit Opportunity Cost

Implicit Opportunity Cost involves the unseen or non-monetary costs of a decision, such as the potential benefits one could have received. The video gives the example of Bob not initially considering the rental income he could have earned by renting out his second house, which is an implicit cost.

💡Trade-off

A trade-off refers to the act of giving up one thing to gain something else. The video explains that every decision comes with a trade-off, such as when Bob chooses to buy a second house, giving up the opportunity to earn interest on his savings. This is closely tied to the concept of Opportunity Cost.

💡Costs / Benefits Analysis

Costs / Benefits Analysis is a decision-making model that compares the positives and negatives of a choice to determine the best course of action. The video presents this model as complementary to Opportunity Cost, suggesting it helps individuals weigh non-monetary factors, such as emotional costs or convenience, alongside financial considerations.

💡Explicit Costs

Explicit Costs are the direct, out-of-pocket expenses associated with a decision. In the video, Bob’s explicit costs include the $10,000 he spends to purchase a house, as well as the $500 interest he misses out on by not keeping his money in the bank.

💡Implicit Costs

Implicit Costs are the opportunity costs of using resources in one way rather than another, which are not always immediately apparent. The video highlights Bob’s implicit cost of not renting out his second house, representing lost rental income.

💡Time is Money

"Time is Money" is a famous quote by Benjamin Franklin that emphasizes the value of time in economic terms. The video references this quote to illustrate how the idea of Opportunity Cost has been long understood, suggesting that time, like money, is a valuable resource that can be wasted or invested wisely.

Highlights

The mental model discussed is called Opportunity Cost, also known as Alternative Cost.

Opportunity Cost is defined as the money or other benefits lost when pursuing one action over a mutually-exclusive alternative.

The formula for calculating Opportunity Cost is: Opportunity Cost = Cost of Chosen Alternative - Cost of the Next Best Alternative.

Opportunity Cost is tied to the concepts of scarcity, choice, and trade-offs in microeconomics.

The term was first introduced in 1894 by David L. Green in the Quarterly Journal of Economics.

Benjamin Franklin’s quote 'Time is Money' is an early example of the idea behind Opportunity Cost.

Opportunity costs can be either Explicit (clear monetary or benefit costs) or Implicit (implied costs).

Costs / Benefits Analysis is a related model, where both costs and benefits are listed and compared to make the best decision.

Explicit Opportunity Costs are defined in monetary terms, while Implicit Opportunity Costs are implied by the choices we make.

In Bob's example, the Opportunity Cost includes both the $10,000 spent on a house and the $500 in interest lost by withdrawing the money from his account.

Bob also has implicit opportunity costs, as he could have rented out the second house instead of using it for himself.

Opportunity Cost is multi-dimensional and not always clear-cut in terms of dollars—emotional costs or inconvenience are other factors to consider.

Using a Costs / Benefits Analysis can provide a more comprehensive view of the Opportunity Cost by factoring in multiple dimensions.

When choosing one option, it is important to consider the trade-offs that the opportunity cost represents.

The video emphasizes that decisions have multiple layers, and a careful analysis of Opportunity Cost can lead to more rational choices.

Transcripts

The mental model we are covering in this explainer video is called Opportunity Cost, also known

as Alternative Cost, we will start by covering some of the basic yet essential facts.

Be sure to keep watching towards the end to find out why the formula for calculating Opportunity

Cost may not be as simple as it first appears.

Dictionary.com defines Opportunity Cost as: "the money or other benefits lost when pursuing

a particular course of action instead of a mutually-exclusive alternative."

All our choices have an Opportunity Cost: it is the value of the best alternative opportunity

that we didn't choose. Ideally, we would want to select the option with the most favorable

opportunity cost.

The formula can be stated as: Opportunity Cost = Cost of Chosen Alternative

- the Cost of the Next Best Alternative

Opportunity Cost is a term from microeconomics and forces us to think in terms of prices

or the value that decisions represent. It is closely tied with notions of scarcity and

choice and is otherwise commonly known as a trade-off.

If we choose one thing, we cannot choose the other, and the best alternative that we did

not choose may cost us in terms of opportunities not acted upon.

Often that's just the trade-off we sometimes have to make, assuming that we considered

our options rationally.

The term Opportunity Cost itself was first mentioned in 1894 in the Quarterly Journal

of Economics in an article by David L. Green.

As is often the case, the idea itself had been proposed in a similar form by earlier

thinkers including Benjamin Franklin, who famously stated that "Time is Money."

In Ben Franklin's "Advice to a Young Tradesman" back in 1748, he says, "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."

The idea of an opportunity cost has been added to by economists since Franklin's writings.

Opportunity costs can be considered Explicit or Implicit.

Explicit Opportunity Costs have the associated costs clearly stated in terms of costs and

benefits whereas Implicit Opportunity Costs are not reflected in cash outflows, but are

rather implied by what one chooses to do with their resources.

When thinking of our resources or potential decisions and their benefits, It is worth

considering benefits because another model closely related to Opportunity Cost is the

Costs / Benefits Analysis.

A Costs / Benefits Analysis is where all of the costs are listed for a given issue and

all the benefits are listed for that issue. They are then compared in order to make the

most rational choice either in favor or against the given choice.

In scenarios where the true cost or benefit is difficult to determine because of many

aspects or dimensions to consider, a Costs / Benefits Analysis may be helpful.

Assuming that we can calculate a cost for our choices, the Opportunity Cost model is

a powerful decision-making ally.

Let's look at an example where we can see Opportunity Cost in action to get a better

understanding of how to apply it.

Meet Bob. Bob is a ________(Doctor).

Meet Mary. Mary is a ________(Realtor).

Mary is offering to sell Bob a house that she owns.

Bob has $10,000 in his bank account where he would make $500 in interest that year if

he left the money in his bank account.

Mary is offering to sell the house to Bob for exactly $10,000.

Bob remembers watching a delightful Youtube video explaining Opportunity Cost and decides

to calculate it for his scenario.

Bob reasons that if he buys the house for $10,000, he would have a second house, but

he would miss out on the opportunity of earning $500 a year in interest.

He tallies his opportunity cost as being not only the cost of the house but also the cost

of not receiving the $500 in interest. This would be his explicit opportunity costs.

Bob decides to buy the second house and is later pleased to realize that there is unused

potential in his second house that he had not taken advantage of.

Bob's second house has implicit opportunity costs which involve the money he could have

made by renting out the second house to tenants instead of merely using it for himself.

After considering the implicit opportunity costs, Bob is pleased with his decision.

Every decision has the potential to be looked at through the Opportunity Cost mental model,

however, many situations are not so clear-cut and are, in fact, multi-dimensional in terms

of all the factors to compare.

There may be a dollar cost to compare, but there may also be dimensions to the issue

that are not typically defined numerically like an emotional cost or inconvenience, etc.

In these cases looking at the situation from a Costs / Benefits Analysis perspective, allows

us to get a bigger picture view of the actual opportunity that our choice presents. This

method lets us consider the Opportunity Cost but also takes into consideration the multiple

dimensions of the issue that may not be recognized when using the basic Opportunity Cost formula

that we presented earlier.

Now let's simplify and review some of the main points we've covered.

A definition of Opportunity Cost is: "the money or other benefits lost when pursuing

a particular course of action instead of a mutually-exclusive alternative."

Our choices have a cost and the Opportunity Cost factors in the price of the alternatives

to the choices we make.

In situations where the cost is difficult to quantify, consider listing the positives

and negatives through a Costs / Benefits Analysis to aid your decision making as you consider

the trade-offs.

If you think the short amount of time you spent watching this video provided educational

benefits that outweighed the potential gains from browsing other videos then consider sharing

this video with someone you would like to help and don't forget to subscribe for even

better videos coming soon. Thanks for watching.