opportunity cost

Why Opportunity cost matters and how to calculate it

Opportunity cost is the impact of the path not taken. Every day life offers us choices, do I drive or do I walk. Should I buy stock or should I buy a painting instead, or maybe splash out on a new laptop.

Each choice comes with an outcome: positive, negative or neutral. What it could have been if I walked to the store instead of driving. Maybe I would have met Warren Buffett. Or I would have ended up soaking wet. We’ll never find out.

I am constantly aware of opportunity cost for a few reasons. It adds a price tag to the path not taken and it reduces regret. Believe it or not but there is a whole game theoretic strategy called minimax regret, aka the sore loser strategy.

It is used to choose a path which minimises the maximum regret of a given decision. But opportunity cost is so much more. Any kind of business venture involves some kind of financial projection.

I’m not talking about a sophisticated financial model. Even a kitchen table business will involve a thought process about risk and potential profit. The problem is that this rarely captures all the economic implications of a given decision.

So how does opportunity cost work?

Let’s use an example with my imaginary friend Steve. A few years ago he bought a small run down restaurant in Manchester. He has ample experience in the hospitality industry so no one was surprised that the restaurant quickly became a thriving business.

However, the margins are tight so he ended up with an average annual pre-tax profit of 35K over the past 7 years. He thinks that the prospects for expansion aren’t fantastic.

One day he was faced with a choice. He was headhunted by a prestigious hotel which offered him 42K pre-tax salary and an opportunity for growth within the company. Should he accept?

Economic profit and opportunity cost

I believe that this is a difficult question. I would argue that answers in social science and in life are rarely clear cut. He may decline as he is a business owner, the word business brings that implicit air of entrepreneurship, growth and opportunity.

Nevertheless, we already established that the growth prospects aren’t stellar. Even so a lot of people would say Are you mad, who in their right mind would swap a business for a job?

This is where economic profit comes into play. There may be a lot of personal or qualitative reasons why someone would stick with the restaurant instead of taking the job.

However, this blog is mainly aimed at hard numbers and maximising profit while reducing risk. So lets look at a numerical example:

Profit – Opportunity cost = Economic profit

So if Steve was to keep the restaurant his economic profit would be 35,000 – 42,000 = -7,000 and of course if he was to take the job his economic profit would be 42,000 – 35,000 = 7,000.

The conclusion is that he should take the job. I need to point out that this is the rational economic choice. Steve could choose not to do that but it is important that he is aware of the economic implications whatever the path he takes.

Some enterprises, which rely heavily on intangible assets, such as technology companies or artists may not be suitable for such an evaluation.

A singer may not choose to forfeit their unprofitable (at a certain point in time) career in the music industry for a low paid desk job. The same goes for a tech entrepreneur.

Has this ever been used on a bigger scale

History of futures

If you are investing you would have heard of futures. They first came around in the 17th century but exchange traded futures contracts emerged in the 19th century thanks to the Chicago Board of Trade.

Imagine that you were a farmer back then and you had a few tonnes of wheat. You could sell it for £10 per tonne in your own village (I’m certain the prices in this example are not accurate, they are for illustration purposes only).

But then your friend tells you that you can sell it for £30 per tonne in London. The cost of transportation, accommodation, storage, etc. is £10 per tonne. So you’d be bagging £10 of economic profit if you go to London. You can either go or live with the regret of the missed opportunity.

A few days go by and all of a sudden you start getting offer after offer for the wheat. You end up selling for £15 per tonne as everyone else rushed to London.

The result of this was that London ended up with excess supply. This drove the price down to £17.5 per tonne, minus the £10 cost of transportation, yielding a net profit of £7.5 or a net economic loss of £2.5 per tonne.

Futures contracts helped to resolve such price uncertainties and currency risk. A 19th century cotton trader could secure the price for the next year without worrying about the exchange rate.

Options

Options have existed in one form or another for a very long time. However, exchange traded stock options first came around in 1973 courtesy of the Chicago Board Options Exchange.

You buy an option and you receive the right but not the obligation to purchase or sell an asset at a pre-determined price.

For example, you think that Apple’s share price is going to the moon by January 2021. Then you purchase a call option which gives you the right to buy the stock at a price of $115 per share and you pay $1000 to have a call on 100 shares.

This option is out of the money at the time of writing as the share price is $114 so it has no intrinsic value. If Apple keeps trading for $114 until the contract’s expiration you just lose your money.

So why is it so expensive? Simply put, to cover the seller’s opportunity cost. If I sold you this option with a notional value of $11,500 I will need to keep the shares until next year so I’m blocking my capital and I may incur holding fees from my broker.

The share price can go up to $200 so I’d lose on the upside or it may tank to $100 and we’d both lose money. Either way the opportunity cost is real and cannot be ignored.

Conclusion

Opportunity cost is an economic construct and is mainly concerned with rational decisions based on financial outcomes. It is important to be considered for any business projects and investments.

However, we are not always rational and I don’t believe we should be. Sometimes people have dreams and want to pursue them, we don’t have to turn into Homo Economicus, a mythical being used by behavioural economists to refer to cold, rational, mathematically driven decisions.