Everyone is familiar with the direct costs of life. You feel it every time you take some money out of your wallet to pay for food, gas, or tuition. Are you familiar, however, with the indirect costs, and the choices that you make everyday? I am not referring to hidden taxes or fees (such as bank fees); I am instead referring to opportunity costs.
The seen versus the unseen
At the most basic level, an opportunity cost is about what is seen, versus what is unseen. When you choose to spend $1,000 on a new flat screen TV, you aren’t just spending $1,000 of your cash: the costs go far beyond that. You are also giving up the ability to pay down $1,000 on your mortgage, saving you many hundreds of additional dollars on interest costs. You are giving up the ability to fund your child’s future education. You are also perhaps giving up the opportunity to save that money for a vacation to your dream destination. You also have to consider all of the time you might spend watching Jersey Shore or something like that.
An opportunity cost is the cost of spending your time, money, and energy on one thing, instead of another thing. As you can see, opportunity costs play a big role in personal finances. Every choice that you make in life has an opportunity cost attached to it, even if it is not easily seen. An opportunity cost doesn’t only include monetary costs, but it includes all real costs of making one choice over another, including the psychic profit of lost time, energy, and pleasure.
Awareness of these opportunity costs is very important. Everything that we do in life has an opportunity cost attached to it. For every decision that we make, an alternative decision is possible, and the difference in outcomes is the opportunity cost that we face. The costs and benefits of these alternate decisions, as well as the unseen effects of the decisions that we do make, must all be considered. Frédéric Bastiat is a well-known economist who popularized the notion of the seen versus the unseen, and why we must always be on the lookout for both.
Personal opportunity costs
Although opportunity costs are an economic concept, they play a part in every personal decision that we make. When I decided to play a lot of games during my high school days instead of focusing on academic performance, I paid the opportunity cost of potentially lost scholarships, bursaries, etc… that could have helped me out in college.
In choosing to work a 9 to 5 job to pay down the mortgage and accumulate savings, I am paying another opportunity cost: The cost of not being able to travel, see the world, and spend my time doing something else and spending more time with the people I care about.
The opportunity costs of political decisions
There are many opportunity costs associated with political decisions as well, and this is one arena where it is very easy to see a strong bias toward the seen benefits with a corollary ignorance of the unseen costs. We can see this with social security, where benefits payments have been squandered by the government over the years, and an unhealthy reliance on public spending has been created. We can also see this with other government actions, such as TARP and the bailouts of Wall Street, as well as other examples of profligate government spending, and the long-term consequences of kicking the can down the road.
I’d like to share another example which has touched my life personally. Most countries these days enforce a minimum wage set by law, and on paper, these minimum wages seems like a good idea. First, we set a price floor on the minimum wage, which prevents businesses from paying their employees less than this price floor. By doing this, we increase the purchasing power of those workers on the lowest rungs of the ladder. This increased purchasing power will then filter around to other aspects of the economy, making everyone better off.
The problem with this analysis is that it focuses solely on the seen effects of the minimum wage, and completely ignores the unseen effects. By setting a price floor on the minimum wage, we also prevent employers from hiring employees below this price floor. These employees are then forced to go on public assistance or to take less productive jobs, or they will be forced to work under the table.
I personally know someone who is training to become a chef. Because of the low margins of the restaurant business and the long hours involved, many restaurants cannot even afford to pay my chef friend in training the minimum wage. How much would this be? At $10 an hour and 60 hours a week, this would be $600 per week; with overtime pay, this is $700 per week. With employer-side overhead and payroll taxes, they could be looking at between $900 to $1000 in total costs per week, if not more. This is the minimum they would be legally required to spend on him. He is not an experienced chef; he is an apprentice, and to pay him that much would be a big risk to take on someone who has not yet proven himself. However, the restaurant cannot legally pay him anything between $1 and $699 per week. My chef friend is therefore forced to either work for FREE, or to accept some payment in other forms or under the table, including working for food and receiving free lodgings.
While this sounds highly exploitative to some people, what they need to understand is that businesses are dictated by cost and revenue. Please note that I am not suggesting that it is OK to exploit employees. Suggesting that these businesses are exploiting employees is looking at only one side of the coin. On the other side of the coin is unemployment and welfare, and a lost chance to climb the ladder and gain real work experience. I personally started out working at far less than minimum wage, myself, though in a legally exempt job.
If an employee is not even allowed to take a job because he is legally forbidden from negotiating a voluntary contract with the employer, he is prevented from having a job in the first place, and that is unfortunate. If a business cannot afford to hire someone at a given cost and they cannot reduce that cost, then they will not hire that person. Not every business is a “filthy rich corporation”, and for many of these people, it can mean the difference between staying in business or closing up shop. My friend, arguably someone on the margins who should be *helped* by minimum wage laws, is punished instead. Because he loves cooking so much, he is willing to do what it takes to learn, even if it means living on the margins, and literally working for food. It is not fair that he cannot negotiate a wage which he and the restaurant would both be voluntarily willing to accept and which the restaurant can afford, or at least, to not be able to do so within the boundaries and protections of the law.
My friend is but one small example of the unforeseen and hidden costs of a “feel-good” law such as minimum wage. These laws enjoy popular support because the seen effects are easy to spot: The minimum wage workers make more money and can take more money home to their families. It feels good to help out those on the lowest rungs, doesn’t it? What is not seen is all of the dollars taken out of the consumers in the form of higher prices, the dollars taken out of the taxpayer in the form of higher taxes to support those made unemployed or unemployable due to the effect of the price floor, and the unforeseen wealth lost by everyone from the lowered output of society.
Those on the lowest rungs are often those hurt the most by the very same policies that were meant to help them out. Customers are forced to pay for it in the form of higher prices and higher taxes, businesses are forced to pay for it in the form of reduced revenue, and employees are forced to pay for it either in the form of lost income, and lost opportunities for gaining experience, or in the uncertainty and insecurity of working for food or working under the table, and without the legal protections of the law.
Opportunity costs and you
My chef friend is paying a significant opportunity cost by pursuing his dream of becoming a chef: He has postponed his education and career. He was close to graduating with a very high GPA in engineering, but he comes from a society where you are not worth anything unless you get a degree and work for a large multinational company, and that is not the path where his heart truly lies.
Finally, to tie this back to personal finance, I’d like all of you to think about the opportunity costs of every dollar that you spend, and what else you could have done with it instead. It’s an ongoing legend that part of Warren Buffett’s notorious frugality comes from the fact that he places a very high bias on opportunity cost. For him, spending $4 on a cappuccino doesn’t merely mean $4 lost today; it also means a potential $40 or more in foregone future earnings and capital growth. As for helping out others, instead of letting your tax dollars try and do that for you and washing your hands of the responsibility, you have the choice of much better ways of giving. The effects of the unseen can work in an advantageous way, here, as a little bit of help directed to the right place can go a long way.
While this thought process can sometimes be taken to extremes, I would like to enjoin all of you to think about what else you could do with your dollars, and to think about these foregone opportunities the next time you decide to spend those precious dollars, or spend your time doing something that does not maximize your life expectation. No matter how wealthy we get, money and time will always be scarce, and therefore we will always have to evaluate the tradeoffs for every decision that we make.
So, reader, what do you think about the role opportunity costs play in your life, and what do you think about my friend’s journey? I have been feeling a little more abstract in my thoughts these days.