Using Opportunity Cost to Your Advantage

I’m tempted by a lot of purchases. Books. Food. Board games. Gadgets.

For me, the best single tool for controlling those kinds of temptations is to give myself a monthly allotment from which I can spend freely. For example, I might cap my personal hobby and entertainment spending at $100 a month and we might have a monthly cap on food eaten outside the home set at $150.

The challenge comes out when I realize that I have more than $100 worth of hobby temptations in a month. How do I figure out the best method for spending that money?

To solve that problem, I’ve been taking advantage of a little bit of economic theory.

What Is Opportunity Cost?

Wikipedia gives a wordy definition of opportunity cost:

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the “cost” incurred by not enjoying the benefit that would be had by taking the second best choice available. The New Oxford American Dictionary defines it as “the loss of potential gain from other alternatives when one alternative is chosen”.

In other words, whenever you spend your time, money, and/or energy on one thing, it means that you can’t spend your time, energy, or money on other things. You only have so much time, money, and energy to go around, so one spending choice immediately eliminates many other spending choices.

An Example of Opportunity Cost at Work

Let’s say I’m at my favorite bookstore. I see a really interesting book on the shelf for $10. Now, I know that $10 is well within the $100 I have allotted to spend on hobbies and entertainment this month.

It goes deeper than that, however. If I spend that $10 on that book, I no longer have that $10 to spend on other things I might want.

In other words, buying that book only really makes sense if there’s nothing else I want more for my entertainment dollar this month.

But how do I know that’s the case? This is where the idea of a “wish list” comes in handy. As I’ve mentioned before, I often jot down items that I want and save them for later. After a month, I re-evaluate whether I still want that item. If I do, then it becomes a pretty high priority. If I don’t, well, then I just cross it off the list.

If there’s something that I wanted a month ago and still want today, it’s going to be a better use of my $10 than a book I saw on the spur of the moment. It’s something I know I want more than an impulsive buy of a book on a bookshelf.

The book I impulsively spot in a bookstore has a pretty high opportunity cost: it means I’m foregoing that item I’ve wanted for the last month. Comparatively, the item on my wishlist that’s been there for a month has a lower opportunity cost: I’m only foregoing an impulse buy that I might not even want in a week or two.

To put it simply, being aware of opportunity cost enables me to make smarter decisions with my hobby and entertainment spending.

Four Strategies for Minimizing Opportunity Cost

Naturally, I want to minimize the opportunity cost when I spend my hobby and entertainment money. When I actually choose to spend my money, I want to make sure I’m spending it on the thing I’m going to get the most value from and thus I’m only missing out on things that have lesser value.

Here are four little tricks I use to make sure of that.

I maintain hobby “wish lists.” I keep lists of books I want to read, board games I want to play, and other hobby supplies that I might want. As I mentioned before, whenever I spy a new item that I might want, I choose to add it to my wish list first and see whether it sticks around. Every few weeks, I clean out that wish list by deleting things I don’t really want any more and ranking what’s still there. If an item has been there for a while and is highly ranked, then I know that item is an opportunity “bargain,” so if I’m out and about and considering buying something, that’s an item I’ll look for and purchase.

I ask myself whether I’d rather have X dollars or this item in question. Whenever I’m about to make a purchase of any kind, I look at the sticker price of the item. Then, I ask myself what would make me happier: a person walking up to me and handing me a pile of cash equal to the sticker price of the item, or a person walking up to me and handing me the item. If I’d rather have the cash, then I know I shouldn’t buy the item.

That’s opportunity cost at work – if I’d rather have the opportunities available from that fistful of cash, then I shouldn’t be buying that item.

I ask myself whether I’d rather have the top item on my wish list or the item that’s tempting me at the moment. In other words, if I’m going to spend this $10, would I rather have this book that’s staring me in the eye or would I rather pay for most of the cost of a book that’s been riding my wish list for months? Or would I rather have something else entirely, like 30% or so of the cost of a board game I’ve been thinking about for a long time?

Finally, I think a lot about the long-term value I’ll get out of a purchase. Usually, I want a purchase to provide an hour’s worth of entertainment for each dollar I spend on it. To buy a book, for example, it needs to be of reasonable length so that it eats up plenty of hours in the reading. For a board game, I either need to be very sure that I’ll play it a lot or that I can easily trade it for something of reasonably equal value if it doesn’t click. Buying an item that doesn’t give as much lasting value has a big strike against it in terms of opportunity cost.

Doesn’t This Kill Spontaneity?

That’s only if you believe that spontaneity has no value. I don’t. I think that being spontaneous has at least some value.

There are often spontaneous moments where I’ll judge the opportunity of the current moment to be worth far more than waiting. I’ve made unplanned purchases of books just so I can get an author to sign the book. I’ve made purchases at big sales when I didn’t expect to buy a thing. Many of the best experiences in life are serendipitous events that you just didn’t expect (though thankfully most of them are free).

How does that add up? An unexpected sale or an unexpected situation where I can get more value than I expect changes the opportunity cost equation. The opportunity lost in paying $15 for a book might not be worth it – but at $5? It’s a different situation. A $20 book might not be worth it on its own, but if it means meeting the author and getting it signed, that changes things.

Just like planned purchases, spontaneous purchases should come with the understanding that you’re giving up other opportunities to have this item or experience. The only real difference is that your time to make that decision is much shorter.

My solution for spontaneity is to save planned purchases for the end of the month.

Let’s say I’ve decided to buy a new pair of headphones for jogging. The kind that I’m eyeing costs $30 and I’ve been thinking about them for months. I decide that at the end of the month, if there’s still $30 in my entertainment budget left, I’ll buy those headphones.

When an opportunity for spontaneity comes up, I can still spend that $30 without much hesitation at all. It just comes with the understanding that I’m giving up the opportunity to have those headphones for another month. Is it worth it? I can decide for myself in that moment.

Doing this creates an opportunity comparison just like what I described earlier in this post. Is this serendipitous hot air balloon ride worth giving up those headphones for another month? It’s a simple question, one that I can answer pretty quickly. Those types of choices leave the door open for spontaneity and also helps me to make smart planned purchases.

Sure, sometimes I make an impulsive purchase and regret it, but that in itself is a learning experience. Over time, that regret helps me to make better decisions in the moment so that I won’t make the same mistake next time.

Final Thoughts

Opportunity cost isn’t a set of strict rules to live your life by. Instead, it’s just another tool in your mental toolbox that you can use to make smarter spending decisions.

The next time you’re considering how to spend money on an entertainment or hobby item, think about opportunity cost. Would you rather have someone hand you a pile of cash equal to the value of that item… or have someone hand you the item? Is there something else you’d rather have than this item? Let opportunity cost be your guide and you may find yourself making smarter purchases.

Trent Hamm
Trent Hamm
Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

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