Tuesday, December 17, 2013

Implicit Cost

The last two articles are about spending and saving. So today, I would like to go a bit further by involving a pretty simple, yet important and well-known, economic concept, opportunity cost, aka, No Free Lunch thoery.

When we talk about implicit cost, we are talking about the cost that is not explicit (anyone can say that), in other words, hidden cost that might be overlooked. In fact, this is one of the many things that distinguishes Economics from other disciplines such as Accounting. As far as I'm concerned (correct me if I'm wrong), accounting does have implicit cost such as the cost resulting from inventory/equipment/property depreciation. However, the one thing about it is that the value is assigned in a rather subjective way. You would not know how long your laptop is going to last, so you would most likely, based on your own reasoning process, assign the annual depreciation value, say by $100 per year. 

However, the implicit cost in Economics is quite different. We call it "opportunity cost" which is whatever you forsake in order to pursue an alternative option. Simply put, it is what you lose in order to undertake an action or gain a certain benefit. Of course, you can never get away from error when ascribing a certain value to something, but what matters is how much/large your error actually is. For instance, by going to your friend's housewarming party, you will certainly miss your favourite TV show, the first episode of the final season of How I Met Your Mother. It is hard to determine the exact value of the show. One way to do it is to ask yourself how much you are willing to pay just to get to watch it while you are partying, which is still pretty vague as it depends on your personal preference/desire/want/need. Though sometimes subjectivity is inevitable, economics always leaves space for a more objective and accurate estimate. In case like buying a new house, you would know exactly that the cost is the high interest you would have otherwise gained from lending the money to your best friend. So if the interest is 20% on $1 million, then the opportunity cost of buying your new luxurious beach house is $200,000. Ouch!

Remember, it is necessary to know what you are getting yourself into. While a business opportunity might look profitable, the profitability might be mediocre at best in comparison to investing in my imaginary company's stocks. 

It is extremely important to understand opportunity cost because you will need to include it in your major (minor too) life decision. For instance, you want to open a McNoodle restaurant. Well, let's just say the daily profit is great. Deducting all the explicit cost, and you have about $50 profit per day. Looking good here, until you decide to grab a calculator and put in your opportunity cost. In this case, it can be your own personal labour cost! Assuming you can work for McDonald at $10/hour, so if you work 8 hours a day, then you would get 80$ daily. Woah! So it turns out you gain more from working at McDonald than the $50 you earn from managing your own McNoodle. That's right, you are actually losing money when incorporating opportunity cost into the equation, not to mention the opportunity of being sued by McDonald for using the "Mc" part of their trademark (Can they really sue you for that? I'm not sure, but it doesn't hurt to take precaution, does it?). I guess that is the reason why we don't see McNoodle anywhere. (lol)

So opportunity cost should always be considered. Do not leave it out. A once seemingly lucrative business idea might turn into a so-so business or worse if you dare to add opportunity cost in your daily number crunching. So my advice is:

"Don't be silly, think wisely, act carefully because the opportunity cost will be thee's enemy, cookies"
The last one is just random. 

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