Opportunity cost
In short
Every choice means giving something else up: money, time or attention put in one place can’t be put in another. Opportunity cost is the value of the best alternative you give up. The idea comes from economics. Decision psychology has shown that people often neglect this cost. When they buy something, they weigh the price against the product, but they don’t spontaneously think about what else they could do with the money. And when they are reminded, their decisions change.
What it says
Opportunity cost neglect. Frederick, Novemsky, Wang, Dhar and Nowlis (2009) start from the observation that, to take opportunity cost into account, you have to actively imagine the alternatives you give up, and people often don’t. They tested the idea with minimal wording changes that add no new information:
- Study 1A. 150 students imagined they could buy a DVD for $14.99. For half of them, the option to decline was “Not buy”. For the other half it was “Keep the $14.99 for other purchases”, which means exactly the same thing. With the first wording 75% bought it, with the second 55%.
- Study 1B. 196 participants chose between two iPods or neither. For half, the price difference was followed only by “leaving you $100 in cash”. Among those who bought, the share choosing the cheaper model rose from 37% to 73%.
The authors note that if people thought about the alternatives on their own, such rewordings would have no effect. The effects also appeared when participants were prompted to think harder about the decision.
How big the effect really is. Maguire, Persson and Tinghög (2023) gathered 39 experiments, published and unpublished, with 14,005 participants in total. They found a robust, statistically significant effect, but a much smaller one than in the original study: d = 0.22, against the 0.45–0.85 reported by Frederick et al. The phenomenon is real, but more modest than the first results suggested.
Even economists don’t agree. Ferraro and Taylor (2005) put a textbook question to about 200 economists. You have won a free ticket to an Eric Clapton concert. Bob Dylan is playing the same night, and a ticket costs $40, though you would be willing to pay up to $50. What is the opportunity cost of the Clapton concert? The authors consider “$10” (50 minus 40) the correct answer. Only 21.6% of the 199 respondents chose it, and the answers were spread almost evenly across the four options. Potter and Sanders (2012), however, challenged that conclusion: they show that, depending on how you account for the cost, every one of the answers can be defended. The practical lesson is that, although the idea is simple, the concrete calculation depends on what you count as the “alternative”.
Example
The example Frederick et al. open with comes from one of the authors’ own experience. He couldn’t decide between a $1,000 Pioneer stereo and a $700 Sony. The salesman asked: “Would you rather have the Pioneer or the Sony and $300 worth of CDs?” The decision that had seemed hard suddenly became easy, and the Sony was at the till moments later. Subtracting 700 from 1,000 was obvious. What was missing was a concrete picture of the $300.
An example built for this text: a free evening. You can spend it scrolling on your phone, and it seems to cost nothing. The opportunity cost is the best thing you would otherwise have done: a book, a walk, a conversation with someone close.
How to apply it
The steps below are a practical approach we propose. The only thing tested in the studies is that spelling out the alternative changes the choice.
- Put the alternative into words. Instead of “do I buy this or not?”, ask “do I buy this or keep the money for X?”, where X is something concrete you actually want. That is exactly the manipulation that changed choices in Frederick et al.’s studies.
- Translate the price difference into something else. When choosing between an expensive and a cheap option, say the difference out loud: “the cheaper option leaves me 300 for…”.
- Apply it to time too. An hour spent in a pointless meeting is an hour that can’t go into something else. Opportunity cost isn’t measured only in money.
- Don’t turn everything into a calculation. Not every small decision deserves analysis. See the entry on maximizing and satisficing.
Limits and nuances
- The effect is smaller than in the original study. The 2023 meta-analysis finds d = 0.22, between a half and a quarter of the effects first reported. Maguire et al. stress precisely the importance of replications.
- Most studies are hypothetical. Participants chose in imagined scenarios or questionnaires. What people do when paying with their own money may differ.
- Could it be just a nudge? An alternative explanation is that the wording “keep the money for something else” suggests to participants that they should be frugal. Frederick et al. tested this: they asked how important being frugal was, how guilty people would feel buying the expensive option and how frivolous the purchase would be. The effect replicated, but these measures did not differ between groups. The explanation isn’t fully ruled out, but their data don’t support it.
- The “best alternative” isn’t always clear. The debate between Ferraro and Taylor and Potter and Sanders shows that, in concrete situations, capable people can calculate opportunity cost differently.
- Neglect isn’t always a mistake. Thinking through every possible alternative has a cost of its own, in time and effort. Sometimes it is reasonable not to.
Sources
- Shane Frederick, Nathan Novemsky, Jing Wang, Ravi Dhar, Stephen Nowlis (2009). Opportunity Cost Neglect
- Allegra Maguire, Emil Persson, Gustav Tinghög (2023). Opportunity cost neglect: a meta-analysis
- Paul J. Ferraro, Laura O. Taylor (2005). Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science
- Joel Potter, Shane Sanders (2012). Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance or an Arbitrary Concept?
See also: Cost of action vs cost of inaction, Maximizing vs satisficing, Sunk cost