Opportunity Cost
K. Wayne Hast
In economics, there is nothing more important to understand than the concept of opportunity cost. The cost of most consumer items are measured in how much you paid for the product or service. For example, a new car might cost $50,000. Most people would therefore surmise that the cost of that new car was the purchase price of $50,000. However, I could argue that the true cost may very well be five times that amount. Opportunity cost would be the reason for my assessment.
Opportunity cost is simply defined as the opportunity given-up when a choice was made, or the cost of passing up the next best choice when making a decision between two possible opportunities. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose for which the asset could have been used.
In my example, the consumer in question made the decision to spend $50,000 to purchase a new vehicle. Let’s assume that the $50,000 is spent on a new SUV. With gasoline still close to $4.00 per gallon the prices of SUV’s have fallen dramatically, making the new SUV look like a very good buy – a bargain. Many SUV’s are currently being discounted 20-25% off the manufacturers suggested price or sticker price. Therefore a vehicle that once was priced at nearly $70,000 may now be had for that enticing $50,000 purchase price.
Let’s assume that the car is purchased for cash and that the total price was actually the $50,000 figure. We need to also assume that the vehicle will be driven for eight years. This is actually about twice as long as the average new car is driven by the initial owner. In-fact the majority of all U.S. automobiles are recycled within twenty years. In 2007 the median age of SUV’s on U.S. roads was 7.1 years old. At the end of that eight year period, the resale value of the $50,000 SUV is no more than 30% of the purchase price or about $15,000. The cost of driving this vehicle is then $35,000. (Note: This does not include costs such as; insurance, fuel, maintenance, and repairs.)
The $35,000 figure is what we will now focus on for this scenario. Let us look at what other opportunities are available for the investment of this amount of funds. The average return on money invested in the S&P has been over 12.7% (with the re-investment of all dividends) over the past 25 years (1979-2008). However, I will to use the return of 9% in this example.
The Rule of 72 – The “rule of 72” is important in economics and personal finance. It can be used for a variety of quick interest rate calculations.
The “rule of 72” says that to find the number of years required to double your money at a given interest rate, you just divide the interest rate into 72. For example, if you want to know how long it will take to double your money at 9% interest, divide 9 into 72 and you get an answer of 8 years.
This quick example teaches us that if the $35,000 that was used for the purchase of that new SUV was invested and had a return of 9%, it would have the potential to actually double to $70,000 during the 8 year ownership period. If we assume that the vehicle’s buyer was forty years of age when the vehicle was purchased, that $35,000 has the potential of increasing to well over $250,000 by the time he reaches the retirement age of 65.
I am sure many of you are saying that’s great, but what would he use for a car. The answer is simple. Use the $15,000 to buy a used SUV. On August 18, 2008, a 2006 Jeep Commander, with 23,000 miles, was listed in the Dallas Morning News priced at $14,000. It will easily last for 8 years. My 1993 Jeep Cherokee has 190,000 miles and serves me very well.
Thomas Stanley in this best selling book “The Millionaire Next Door” lists the three important traits of a millionaire as: Frugal … Frugal … Frugal. He points out that a majority of American millionaires buy their cars used and drive the wheels off of them. He also has other interesting information such as most millionaires that he has interviewed have never paid more than $500 for a watch. They live below their means, don't rely on credit cards, and invest wisely. Most of these millionaires came from modest backgrounds and have learned that it's much better to earn interest for themselves than to pay interest to someone else.
Many of our rich do not live like they are rich. Investment mogul Warren Buffett is a great example. This 77-year-old is one of the wealthiest people in the world, with a net worth estimated at over $60 billion. However, he lives in the same three bedroom corner-lot ranch home that he bought 50 years ago in Omaha, Neb., for the price of $31,500.
Mr. Buffett is not alone in his frugality. I recently heard of a man in his late 30s, who lives on about $50,000 a year in San Francisco, quite a feat, considering the Bay Area has one of the highest costs of living in the country. However, what makes his situation so impressive is that this man is a dot-com multi- millionaire. He doesn't own a TV, drives a gas-thrifty Toyota Prius and listens to music on his $20 MP3 player. He's frugal by choice, and he states matter-of-factly, "I don't need a lot of material possessions." He is not alone. Many young people who have become wealthy are very mindful of using their money wisely.
Many of these wealthy young adults aspire to leave the world a better place than they found it. And those with considerable wealth are having an awakening. Many famous athletes such as the Dallas Cowboy’s Jason Whitten are creating charitable foundations. Jason recently launched the Jason Witten SCORE Foundation, established in part to provide support and assistance for families and individuals affected by domestic violence.
These stories of responsible young and wealthy people are particularly inspiring, because people in their 20s and 30s are generally known for being materialistic and irresponsible with money. They have been painted as being obsessed with wealth, luxury and themselves. So if these young millionaires think they need to be mindful of their money, shouldn't all of us become more faithful stewards of our money and wealth?
What was the opportunity cost of buying that $50,000 SUV? I think you know.
Note: As an economist and economic educator, I have spent my career explaining to students, friends and often anyone who will listen, the importance of an economically literate electorate. The objective of this article is to give readers an opportunity to gain a better grasp of the economy within which we as Christians live and work.
K. Wayne Hast is a graduate of Dallas Baptist University and has served as a DBU adjunct faculty member since 1991. He is currently the President and CEO of Financial Education Fellowship, and served for over a decade as Director of Economic Education for the Federal Reserve Bank of Dallas.
© 2008 by K. Wayne Hast
