Individual Opportunity Costs

Everyone has a price. At work the other day, we were playing the “what if” game, after a particularly horrifying happening on Fear Factor. It was along the lines of “Would you ever cheat on your spouse?” “No? But what if Bradley Cooper was on your bed naked?”.

We established that everyone has a price. Everyone has a limit of how much self control, resistance, or willpower they have before the rewards for the action opposite outweighs the rewards for the desired action.

This applies to your finances, as well, and this is why personal finance is so very personal.

can't buy anything on credit

An example I have exhibited recently is with my car. I wanted to save; my intentions where to bring my net worth up by a substantial amount in 2012. I also wanted to go on a trip and be able to buy a new couch. My “price” was the prospect of having no car.

In simpler terms, I was excited and more than able to save for all of those things I listed above, but I wasn’t willing if it meant having no car. I obliterated my plans to reach those goals by taking on new debt, because for me, the opportunity cost of having a car outweighed the opportunity cost of buying those things and increasing my net worth.

Where this really gets people in trouble, is if their opportunity cost for material things or spending frivolously is higher than their opportunity cost for paying bills and being financially responsible.

In simpler terms, people get in trouble when their opportunity cost for the “wants” outweigh their opportunity cost for the “needs”.

Sure, paying for food and hot water, health and shelter, those aren’t fun things to have to pay for. I’d, too, rather spend my money on trips to Mexico and a cute dress from my favorite store.

But will I do that at the cost of my ability to pay for my means of getting to work?

If debt wasn’t an option, we’d really be able to see where our opportunity costs lie. If I wasn’t able to take on the car loan, would I have spent my entire income on a car, or would I have realized I couldn’t afford to do that and moved closer to work and school?

If debt wasn’t an option, would some of the people that Gail Vaz Oxlade helps on ‘Till Debt Do Us Part let their homes foreclose to pay for their boats and lattes, or would they cut those out of their daily spending diets?

Where do your opportunity costs lie? What are you willing to forgo for your lattes, your iPad, and your Manolos?

Before sinking yourself into more debt by purchasing that dress in the boutique below your office, think about this “If I didn’t have a credit card, what would I be not paying for to buy this dress?” If the answer is nothing, because you have more than enough cash in your account for the dress, your bills, and your savings, great.

If the answer is security, or the contribution to your emergency fund, you should be weighing the opportunity cost between your financial security and the amazing pattern of that adorable dress.

What if the answer is your RRSP or Roth IRA contribution? Are you willing to forgo your future stability for a dress you’ll grow tired of in six months?

Weigh your opportunity costs as if debt wasn’t an option. It's hard to do, because debt is an option for most of us, but it really helps put some things into perspective.

27 thoughts on “Individual Opportunity Costs

  1. bax

    Fighting the self image of "I can't drive a beater car" has been a difficult road for me. I'm interested to hear more about how this impacts your plan.

    Reply
  2. It's amazing how your decisions change when you take credit cards out of the picture.

    I relied on them for a long time. Even after putting them aside and only paying cash, it still took a while to get out of the mind set of buying things just because I could.

    After figuring out that we could be out of debt in 55 months if we don't change a thing motivates me to not frivolously spend money. Because if I spend less, then we'll be out of debt sooner!

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  3. Interesting points on opportunity costs. I think it is much easier to make those decisions when you really are tight for money. When you have more than enough money, then willpower gets tougher to maintain. When you should be putting extra money aside for retirement, it is so much easier to convince yourself that you need a vacation or a new car.

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  4. I put all my monthly expenses on my credit cards except for rent (I pay them off in full every month), but sometimes I wonder this too. Would I really be buying that magazine and those chips at the drugstore if I didn't have the option of my credit cards? Probably not. We forget that the concept of credit is a relatively new one and that not too long ago, people saved up money for any purchase, not just a select few.

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  5. John | Married (with Debt)

    I traveled a lot in my twenties, but I still will probably look back and say I wished I'd traveled more: that's because I love it so much.

    I feel bad for people who truly never went anywhere, and when they finally could, they were so beat up and old from life they didn't have the drive to do it.

    That will never be me.

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  6. I try to get myself to think about opportunity costs at different points. I've written about it a few times, as I recall. When I think of spending on something truly discretionary, I like to think about what that amount of money will be in the future.

    Example: eating dinner at home for $5 today versus $15 outside will save $10. Invest that $10 at a healthy rate of return, and in today's purchasing power maybe it will be worth $20 or $30 in, say, $25 years? With bigger ticket purchases, this amount adds up. It's what we're giving up now and in the future.

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  7. Don't forget the cumulative effect of small little purchases over time. $4 for a latte might not seem like much but 200+ a year (or more) * 10 years = house down-payment!

    I'm now 37 y/o and if I hadn't purchased a home espresso machine, my family finances would easily be $25,000 to $50,000 worse off then they are now since 1998.

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  8. my friends and I used to play that game all the time, my coworkers and I play it also. In terms of opportunity cost you are absolutely right, it is a matter of thinking that way when you are wanting something. Sometimes we want something so bad we don't care about the opportunity cost.

    Reply
  9. I love this! This reminds me of sooooo many things in my life. Especially home buying. We kept on looking and looking but if we wanted to pay less money, we'd have to sacrifice a lot of things we initially wanted. If we paid more, we still had to sacrifice! There was always, ALWAYS a catch. Also this reminds me of Once Upon a Time (the show on ABC). Rumpelstiltskin always says that magic comes with a price, because people always want something but they need to give up something truly important to them as well. Most of the time the characters do get what they want and then later remember that they must pay the price! So true with personal finance, and life in general.

    Also I was hoping you could read my last post and give me advice. I know you said your BF and dad, and stepdad are all very handy people. Do they have any experience in installing windows? I was wondering if you could find out how much a floor to ceiling window would cost to install? If you look at my last post it shows a picture of it... there is a window in this condo that is fully open (permanently)! You can't close it so you can hear things outside and the air comes in....very weird.

    Thanks Daisy!!! :)

    Reply
  10. Great post! This really helps put things into perspective for people.

    I like the comment you make at the end about Roth IRAs/retirement. Most people only see the here-and-now...so we weigh the OC's based on the bills today and what we give up today to go into debt.

    But where most people fail is going into debt and foregoing being responsible for the future.

    We can handle the car/house payments in the here-and-now, but can you really?

    The reason managing money well is so difficult is because you must live on less than you make now WHILE saving properly for your retirement. We have our personal OC's but we typically only take today and tomorrow into account...we don't see the long-term effect that buying that house or car has on our long-term ability to build wealth and retire financially independent.

    Reply
  11. Super Frugalette

    I am pretty picky on dresses...when I find something I like, I have it for years...but I wouldn't pay for one on debt to have it.

    Reply
  12. Ella

    I guess the thing is that it is easy to unfocus. If you focus of your goals either it is paying down debt or saving money, losing weight or whatever, it will help you make the right choice.

    Reply
  13. Oh gosh I used to be horrible at this! Essentially everything I was buying meant not paying down my debt. Now I think twice about every purchase because each dress means less money going towards my loans! I have 3 weddings this summer though but luckily by then my debt will be paid off and I can un-guiltily buy a dress or two :)

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  18. When you put the question like that, it really makes sense. I think a lot of people really don’t consider all the things they could have in exchange for those relatively less significant purchases. Many people I know refuse to save for retirement or an emergency fund because it cuts into their fun. But how much fun will it be to work until you’re 70 or be $20,000 in debt when you finally need a new roof on the house? Does our culture just have a serious lack of planning ability?

    By the way, I love the cartoon above!

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