A customer is having a difficult time deciding whether or not to purchase a new car. How would understanding the concept of opportunity costs help this individual make a decision?

The decision must be made after the following things are known:

  • Amount of funds required to buy the car with down payment
  • Cost of the car in terms of price or in terms of the monthly payout to the loan she takes for the car.
  • Alternative Uses of her funds.
  • Costs of using an alternate mode of transport.

Assume that the customer has some funds of her own that can buy the car. She can use these funds for alternative uses. One is to buy the car. She can invest the money in bonds that fetch her 5% return. Another option is to loan the money at 10% rate. If she does not use her funds she can take loan.

Clearly a loan will be taken only if the interest is lower than 5%. Assuming this is not the case then we can consider the above 3 options. She needs to compare the return/ benefit from the use of the car against alternative uses of the money. The valuation of the benefits of a car are subjective, and must be compared against the benefits of giving up money  and earning different rates of interest.

 The opportunity cost of her funds is based on 3 uses of her funds:

  1. Benefits from car
  2. Rate of return of 10% from bank
  3. Rate of return of 5% from bonds.

The choice depends on the comparison among the three, as the customer will opt for the highest option. Let us say that 10% return is highest, followed by having a car and then 5% return. . In that case the opportunity cost will be the highest cost of alternatives that are foregone—using a car, which is >   benefit of 5% return. A rational choice means that the opportunity cost is lower than the benefit from chosen option. Opportunity cost is therefore, the cost of the ‘next best’ alternative that is foregone. 

The concept of opportunity cost tells us that any choice among alternatives is based  on a comparison of benefits. The chosen option must give highest benefit, so that opportunity cost is the highest benefit among the options that are foregone.

Now let us say that the benefit from car is valued highest followed by money in a bank and then money in a bond. Clearly the choice will be to choose car and the opportunity cost of funds will be interest at @10% .  the opportunity cost will be the loss of interest at 10% and this will be lower than the benefits of having a car.

In this way opportunity cost rule tells us that every rational decision involves a choice, where the benefits from the chosen option must be higher than the benefits of foregone alternatives.

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