What's It Costing You?

The following is a guest post by Gary Foreman, the editor of The Dollar Stretcher.

One of my favorite quotes comes from Henry Ford. "Thinking is the hardest work there is. That's why so few engage in it." Old Mr. Ford was an interesting man. He made some very good decisions (produce an affordable car for the average man, use an assembly line with interchangeable parts) and some very bad ones (sticking to old designs too long). That makes him a perfect person to help us understand an economic concept called "opportunity cost."

What is opportunity cost? It's a theory that states something that we already know. Sometimes you have two or more alternatives, but you can only choose one. To put it in a more scholarly way its choosing between mutually exclusive choices.

For example, suppose you were shopping for a new car. You've narrowed it down to a minivan and SUV. Both about the same price. You have to choose between the two. You cannot have both.

After test rides you decide to choose the minivan. That's your opportunity. The ability to choose the van. The cost is the loss of the SUV.

Another way to think of it is 'instead'. If I go to a restaurant, I can choose the meatloaf instead of the fried chicken. But if I've already eaten the fried chicken, I'll be too full to try the meatloaf. So choosing one eliminates the other.

The theory of opportunity cost relates to both our time and our money. Let's consider a college student. Suppose that spending a semester in college costs $6,000 (including all fees and living expenses). But that's not the real cost. The real cost would include the $8,000 he could have earned if he were not busy in college. So the true cost is $14,000.

The same is true on a smaller scale. I can choose to clean the gutters or watch the football game. I can't do both. If I decide to watch the game the gutters will continue to be full of leaves. Making the same decision weekend after weekend could lead to damage to the house. In effect, the cost of watching the games was the repair of a leaky roof.

But, let's get back to Mr. Ford. What makes him such a prime example for opportunity costs?

The initial Model T Ford sold for about $500 (depending on model and which year it was purchased). People who bought a Model T could have spent that money in other ways (farm equipment, newly invented labor saving devices for the home like washing machines or vacuum cleaners, etc). The opportunity cost to buying the Model T was that they couldn't buy the other things.

By stressing a mass market and low prices, Ford lowered the opportunity cost of his car. People had to give up less stuff to buy one. As a result Ford sold nearly 15 million cars between 1909 and 1927!

But, Mr. Ford also made some bad choices. He stayed with the Model T too long. By staying with the Model T, Ford couldn't introduce an all new car. That was the cost of sticking with the T. It was an expensive decision. From 1920 to 1926 Chevrolet's production went up by 400%. Ford's decreased by 20%. Ford's early dominant position in the industry was lost.

What can we learn from Henry Ford's example? Mainly that we should think before we make big decisions. Often the opportunity costs aren't that apparent. Had Ford recognized what it was costing him he probably would have replaced the T earlier.

We need to do the hard work of thinking, too. The cost of that minivan might not just be the SUV that we didn't buy. It might mean that a change in income could force Mom into an evening job to make the payments. The cost of being away from her children could be very expensive (lower grades, teen pregnancy, gang involvement). Take the time to consider the different alternatives and how each option could play out in the future.

Henry was right. Thinking is hard work. But, it can also be very well paid work, too!

Related Reading:

Why Government Debt Matters to You

11 Ways to Go Frugal

1 comment:

  1. Always, always go with the fried chicken! Such a mess to make at home :)


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