Core Principle 2 - The Opportunity Cost Principle - Or What?

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With She's Birdie, you can bring peace of mind with you. BirdieBox is a portable travel door alarm for hotels, dorms, Airbnbs, and anywhere you stay away from home. Just attach it to the door frame, switch it on, and if someone opens the door, BirdieBox blasts a loud siren and flashing alarm to alert you and everyone nearby. Because the best part of travel isn't worrying. It's sleeping sound. BirdieBox from She's Birdie. Locking in peace of mind wherever you stay. For safer, more confident travel, visit She'sBirdie.com. That's S-H-E-S-B-I-R-D-I-E dot com. Hello, my love. I'm Ryan Weiss, and for the past 15 years, I've been an emotional intelligence coach and a spiritual guide, and I'm sharing with you my new podcast, Waking Up With Ryan. Waking Up With Ryan is a daily audio video podcast here to help you connect with yourself, before the noise of the day takes over. So let's start our days together with a moment of calm that's just for you. Listen to Waking Up With Ryan on the iHeartRadio app, Apple Podcasts, or wherever you get your podcasts. - Himalaya. - You're listening to Think Like An Economist, a Himalaya learning production. For exclusive content, you can find it on our website at ThinkLikeAnEconomist.com. Think Like An Economist is a production of Himalaya Learning. For exclusive content, listen to Waking Up With Ryan on the iHeartRadio app, Apple Podcasts, or wherever you get your podcasts. For content like bonus episodes and extra material, go to Himalaya.com and enter promo code ECON, E-C-O-N, at checkout to get your first 14 days free. It's time to Think Like An Economist. - Thinking Like An Economist is why I don't eat donuts even when they're free on the morning meeting platter. - What do donuts have to do with it? What do donuts have to do with thinking like an economist? - More than you think. I mean, I'm trying not to overdo the junk food. And so if I have a donut at the morning meeting, I won't have a bowl of ice cream after dinner. To give you the full economist speak, the opportunity cost to me of eating a donut in the morning is a bowl of ice cream after dinner. And because I think like an economist, I choose to forego the donut so I can eat the ice cream. - But Justin, you can have both. - Actually, I can't if I care about my heart and my waistline. - Welcome to Think Like An Economist. With me, Betsy Stevenson. - And I'm Justin Wolvers. We're gonna teach you how to make better decisions throughout your life. Be it buying a car, choosing your career, or knowing if you should eat that extra donut. - We're gonna speak to people running small businesses and central banks and to the different generations of a family to teach us how to think like an economist because it will transform your life. Journalist and former economic student Naz Turan Tavakoli joins us. - Hi Betsy, hi Justin. We're going through the four core principles which you say underlie almost all decisions that we all make. So last episode, we looked at the cost benefit principle. What are we gonna look at today? - We're moving on to the opportunity cost principle. We define it this way. The true cost of something is the next best alternative you must give up to get it. So let me give an example. In many cases, the most important opportunity cost of going to university is having a full-time job. That's because most university courses require enough of your time and attention that it's gonna be impossible to hold both a full-time job and to be going to university at the same time. Sure, there are people who do juggle both, but that comes with a different set of opportunity costs like giving up sleep, exercise, or time for friends and family. - So you're talking about the next best alternative? - Exactly. Now, this is important to us. As in our last episode, we went through the cost benefit principle. The thing is when we make decisions, we need to look at the full set of costs that a decision involves. The full set means not just the out-of-pocket or the financial costs that we can count in dollars. - Yeah, the opportunity cost principle really gets us to think about alternative uses for our time and our money. It makes us look at the consequences of our choices and to think about alternative uses for our time and money, or rather, to consider the trade-offs of our decisions. Opportunity costs are so fundamental to decision-making that often when we economists talk about costs, we're talking about opportunity costs. - Okay, so basically we're broadening the meaning of costs to not just refer to the money we pay for something, but also anything else we might give up. - Yes, and let's go through some examples so we can really grasp this. So Naz, say you wanna study an extra hour of economics after work because you're learning how to think like an economist. So this doesn't cost you anything out-of-pocket, but your time is scarce, and an hour after work studying economics is an hour you can't spend studying something else, say learning the piano or catching up with a friend. And those things can be equally important for you as an extra hour of economics. You should only spend an extra hour studying economics if the benefits are at least as large as that next best alternative. - I think this really hits on a key point, which is that time and resources are scarce, and that's what the opportunity cost principle highlights. Whenever you choose to do something, you're implicitly choosing not to do something else. So let's make it explicit. We don't just have limited money, we also only have 24 hours in a day. If you're like me, you have limited attention, maybe limited willpower. The scarcity of these resources imply that you'll always face a trade-off when you're making decisions. - So wait, this sounds like that famous poem, "The roads are not taken." - Exactly! - Two roads diverged in a wood, and I, I took the one less traveled by, and that has made all the difference. Robert Frost got it. The road not taken is the opportunity cost. It's the next best alternative for Frost's character. So you see, economics really is poetry. - So with the cost-benefit principle, we basically looked at how much we were willing to pay for something so that we could figure out, figure out the benefits. So what do we do when we're trying to factor in the opportunity cost of something? - So the opportunity cost of something is what you give up to get this thing. So you need to ask yourself two questions. Question number one is, what happens if you pursue your choice? And question number two is, what happens under your next best alternative? - Okay, so let's look at a case study so we can really dig in. - Hi, I'm Alana. I'm gonna be starting an MBA this fall. Alana, she's been working for a nonprofit in China for a few years, and she recently moved back to the US because she's preparing for her upcoming MBA. - Three years ago, I decided that I wanted to pursue an MBA because it's one of the easiest ways to drastically increase income. And I also wanted to diversify my employability and the types of sectors that I could work in and the kind of work that I could do. - What is it that you want to get out of your work? What's the main motivation that you have? What do you have for you? - I'm looking for more opportunities and for stability. - How much is your tuition for your MBA? - My MBA program is two years. For the first year, the tuition is about 51K US dollars, and I will be paying 15K USD. - The tuition's 51K, you'll be paying 15K. Where is the rest of the money coming from? - I was fortunate enough to receive two merit-based scholars, scholarships from my school, as a part of my admissions offer. - Congratulations. - Thank you. - Do you know how much you'll be paying for room, board, living expenses? - I've estimated that I'm gonna be paying 32 to 35,000 US dollars a year in living expenses. - Let's quickly stop and do some calculations. - So the first thing we need to look at is the cost of her choice to pursue an MBA. You might think the big expense is tuition. So she's gonna be paying $15,000 a year, because she's smart and she's gotten some scholarships to cover the rest. She'll be spending up to $35,000 a year on living expenses. Now we need to look at the cost of her next best alternative, which is to stay in her job. - The last year I worked, I made $39,000 after tax. I paid somewhere between 600 and 800 in rent, probably a similar amount on food each month. I had a few other expenses that brought things to about $25,000 that year. - And what did you do with the rest of the money? - I put the rest of the money to a savings account. Since her next best alternative to going to graduate school is to stay in her job, she'll be foregoing that salary she was earning, that $39,000 in income. She said she spent $25,000 this past year on living expenses. So how do we calculate her opportunity costs? And let's just do this for one year and see what we get. Okay, so she'll be paying $15,000 in tuition. We're going to add to that what she won't be earning from her job, which is $39,000 in foregone income. That gives us a total of $54,000. Now let's look at her living expenses. This past year, she spent $25,000 on living expenses, but she estimates she'll spend as much as $35,000 on living expenses during her MBA. This is an extra $10,000 she'll be spending. Adding this to the $54,000 we just calculated gives us $64,000. So her total opportunity costs for doing an MBA for a year is $64,000. Plus any kind of incidental one-off costs that she thinks she might face as she transitions to graduate school. And how about her time? Because we keep talking about the importance of time in this episode about opportunity costs. How does that factor in here? Well, she's leaving full-time employment to study full-time. So these cancel each other out. Either way, she'll be working pretty much full-time. She's just swapping a desk at her job for a desk at her school. And so is it worth doing the MBA given this? I mean, $64,000 is a lot of money. Well, this depends on how valuable the MBA will be in achieving her goals. And realize everyone may have a different goal for going to school. It isn't always just about boosting your income. It could be the joy of learning or other factors like just pursuing the passions that you face in life. Let's hear what she says. I really want to take this time to understand where the market is going and what's going to be most important, not just two years from now, but 10 or 15 years from now. Because I really wish when I did my undergraduate degree that I had looking at the market and where the most employment opportunities were going to be. And how much would you like to earn after your MBA? As much as possible. My school has like a 99% job placement rate within three months of graduation. And the average starting salary is about $120,000. And a 99% job placement rate after three months of graduation. That sounds pretty good. For someone who wants more stability and better job opportunities, it sounds like an MBA is going to be the right decision for her. A good trick to make sure you're applying the opportunity cost principle is to make sure that the word or is in the middle of your sentence whenever you make a decision. For instance, don't just ask, should I get an MBA? Ask, should I get an MBA or should I get an MBA? Should I continue working full time? And you can often list more than one alternative. Naz, let's have a crack at this. What is the opportunity cost to some of the following decisions? Should you hire your best mate to work for you? Or should you hire someone else? Or should you put up a posting on a message board? And so the opportunity cost is the best of those alternatives. Let's try it again. Should you spend all of your income? Or should you save some of it? To think about spending later. Look, we can make these more complex, too. Should you save that money in the bank? Or should you put your money into stocks? Yes. And the full decision is actually this. Should you save your money in the bank where it will be safe, but the value of your savings won't rise by very much? And on your side, Naz? Okay, so I said, or should you put them into stocks? I guess where your money may increase in value, but it might also lose value. So basically, I'm going to say, should you save your money in the bank where it will be safe, but it might also lose value. So basically, you're deciding about how much risk you're willing to take. Exactly. And this is the thing to remember. The answers to these questions are unique to you. So when you think like an economist, you'll be applying the tools of economics to make decisions about your unique life. Is there anything we need to be careful about that can sway our decision making the wrong way? There's a really interesting question. There's a great implication of the opportunity cost principle, and it's all about sunk costs. Sunk costs refer to the money you have spent that you can't get back. And here's where the opportunity cost principle offers you concrete advice. You need to ignore sunk costs. It's so important that I'm going to say it again. Ignore sunk costs. Unfortunately, instead of ignoring sunk costs, people ignore the advice to ignore sunk costs. They do it all the time. Look, you're right. You're right. You're right. You're right. You're recognize it in yourself if you can remember the times where you dwelt on all the time and money you've already spent on a project. I've got some friends who'd run a cafe for a few years. They'd invested tens of thousands of dollars and thousands of hours doing marketing and spreading the word and it just wasn't working. But their reaction was, we can't leave now. If you find yourself in their position, remember one big idea. You can leave it. And all the time and money you've spent, say on that cafe, are irrelevant right now. You'll never get it back. You really need to ask about now. What is the best choice to make now? So a bit like let bygones be bygones and focus on the future. Yes. Sunk costs aren't opportunity costs. You've sunk all that money and all that effort. When you ask all what, you realise that those sunk costs are irrelevant to your future decisions. If you haven't really practised thinking like an economist, you might find it hard to ignore sunk costs when you're making decisions. But you really need to. Yeah. So I feel like we see sunk costs all the time. You know, people stay in bad relationships because they've been together for years or people will train to be a lawyer or some other profession where they need to do a lot of training. And, you know, they've done all the work, got on the degree. They might hate the job, but they keep doing it because they've spent all that time getting trained up. Yes. Channel your inner Elsa. Let it go. Once you learn about sunk costs, you'll be so liberated, you'll make better decisions about the present and the future. So we're going to go through a few more examples to really get it. You'll see how significant opportunity costs are in explaining our decisions. So, you know, when you go into a work meeting and there are free doughnuts and pastries and things. Yeah. Usually if it's a morning meeting as an incentive for people to turn up. Right. So I never eat those doughnuts, even though they're free. And that's because I'm an ice cream fan. But Justin, you can eat both. I could, but I also want to be pretty healthy and I want to limit the amount of sugar I eat every day. So to have a reasonable sugar intake, I can either eat a doughnut or a bowl of ice cream after dinner. I love my after dinner bowl of ice cream. So the doughnut goes. So the opportunity cost of eating the doughnut in the morning meeting would be foregoing your bowl of ice cream after dinner. Yes. Even though the doughnut's free, it comes at too high of a cost. Did you know a recession is good news for Netflix? Their revenues often boom. I didn't know this, but let me have a stab at this. So I'm thinking recession, you might have lost your job. So you've got more time to watch things. Exactly. The cost of Netflix isn't just the price of the streaming service, but it's the time you spend actually watching things on Netflix. You could be working and making money instead of watching TV. But when the economy is struggling, there are fewer jobs, which means less work to do. So the opportunity cost of your time is lower. And this is why the streaming industry actually does really well when the economy is struggling. We've just learned about the opportunity cost principle. Let's summarize. The opportunity cost is whatever you're giving up to do the thing you want to do. Think about your next best alternative. What would you do instead of what you're about to do? And how much is that alternative worth to you? If you want to make sure that you're using this principle all the time, always be asking, or what? That's what the principle is all about. Is there anything we can practice to really get to grips with the opportunity cost principle? As you go about your life over the next few days, practice asking yourself, or what? For all the decisions that you're making. So you really start to identify what those alternatives are that you're giving up. And as you practice getting in the habit of, always asking, or what? See whether it helps you identify costs or benefits that you might otherwise have overlooked. And so what are we going to be looking into on the next episode? Next, we're going to turn to the marginal principle, and we're going to teach you how to think on the margin. Cool. Okay. So we'll speak to you all next time. Great talking to you today, Naz. I'm Betsy Stevenson. And I'm Justin Wolfers. And this is our podcast. Think. Like. An. Economist. To get the most out of this show, check out our bonus episodes and supplemental materials available only on the Himalaya Learning platform. Himalaya Learning provides bite-sized courses from world-class thinkers and industry experts such as Arianna Huffington, Malcolm Gladwell, Tim Ferriss, and more for you to enjoy in the app on the go. To get the most out of this podcast and others like it, go to Himalaya.com. And enter promo code ECON at checkout for your first 14 days free. Because even the nicest room can feel unfamiliar at night. It's sleeping soundly. Hello, my love. I'm Ryan Weiss. And for the past 15 years, I've been an emotional intelligence coach and a spiritual guide. And I'm sharing with you my new podcast, Waking Up With Ryan. Waking Up With Ryan is a daily audio video podcast. Here to help you connect with yourself before the noise of the day takes over. It just came out. Jeremy, what did you just do? Sit yourself up for failure. I've never heard you tell this story. I've never told this story. This must have been tucked deep, deep in the Jeremy Lin file. My name is MC Jin. 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