Understanding Financial Decisions in Light of Opportunity Cost

“One of the key lessons of the recent financial crisis is the importance of personal financial literacy. Besides improving their personal financial decision making, teaching students economic principles will help them as citizens understand and make choices about many of the critical issues confronting our nation.” –Ben Bernanke, Chairman of the Federal Reserve System.

Just like other healthy habits, patterns of smart financial decisions include adopting a new mindset. When it comes to money, this frame of mind comes from looking at each personal financial decision in light of opportunity cost. Opportunity cost is crucial because we value other things besides money, think time and energy, and we must take them into account when we assess a choice. It looks beyond the direct monetary costs in each decision to the indirect costs, what you lose when you chose one alternative over another.

For example, imagine that you are at your favorite restaurant on Friday night and confronted with the decision of which dinner to choose. You’ve had a long week at work and are tempted to choose the $20 steak meal, but you also could be satisfied with a sandwich which costs only $10. Additionally, there is a new movie out that you wanted to see sometime this weekend. If you keep opportunity cost in mind, you are able to assess the choices more clearly, beyond the here and now, since you realize that you would be giving up both the sandwich and the movie for the enjoyment of the steak meal. So the question is: which allocation of resources will make you happier overall?

In the big leagues, opportunity cost becomes an even bigger player when it comes to purchases like a car, house, or college education. You can weigh the pros and cons, stare at your bank account, but a clear understanding of the next best way that you could allocate your money is a necessary thing to grasp. All decisions require sacrifices, and being able to visualize the alternatives to a course of action will serve you well when deciding which sacrifices you are most willing to make.

To conclude, opportunity cost, defined by Investopedia as “the benefits you could have received by taking an alternative action,” is an essential tool to help you make the best use of your money and resources.

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