Opportunity Cost (of being a consumer)

Preface

Whenever spending money to consume a good or a service the first cost that comes to people’s mind is the nominal cost, which is the price listed for the good or service in money. For example when you go to Starbucks and buy a $5 coffee the nominal cost is $5, but that doesn’t even come close to the real cost of the consuming that $5 coffee. It took you time to drive over to the Starbucks, wait in line, place your order, wait for the barista to whip it up, and finally to drive it back. I have already loosely covered this time based cost in Money Can’t Buy Time, but for the duration of this post I want to focus on the “opportunity cost” of common goods and services people spend money on. Opportunity cost is defined as the benefit of the best foregone option less the benefit of the chosen option (https://www.investopedia.com/terms/o/opportunitycost.asp). Now like all things in economics the formulas are simple, but the variables are very much subjective. In this scenario I can tell you that the cost of coffee is $5 + 20 minutes of time + (benefits of the best option foregone - benefits of the coffee), but I don’t know what 20 minutes of your time is worth, I don’t know what your best alternative is, and I don’t know how much you benefit from coffee. All I can say is that if the true cost of coffee comes out negative for you, then you should purchase it, since the benefits outweigh the costs. What I will give is a framework / approximation for how to tackle this situation. For the duration of this post I will be going over one alternative of consuming a good or service, which is investing in the company that produces that good or service. In the case of $5 coffee you would invest $5 in Starbucks instead of $5 coffee. Essentially I am trying to measure the opportunity cost of being a consumer as opposed to an owner.

$5 Coffee

Suppose instead of buying $5 coffee from Starbucks you instead invested that amount in Starbucks. This small decision will convert you from a consumer of $5 coffee to a part owner of a global coffee franchise that sells $5 coffee to $5 coffee consumers. Suppose you did this every day for the 252 trading days in a year (and at the time of writing this post), then here is how much you would own in starbucks shares:

These numbers were derived by taking the historical stock price for SBUX and dollar cost averaging $5 for every trading day.

Note that this doesn’t even include the fact that SBUX has a great dividend at 1.9% meaning that if you owned $66,315.78 worth of SBUX the dividends alone would be enough to pay for $5 coffee every trading day for the rest of your life. That right there is the benefit of being an owner as opposed to a consumer.

Now you might say that coffee makes you more productive throughout the day and thus why are you okay with spending $5 everyday on it. I won’t argue that coffee has it’s benefits, which is why I want to just propose the idea of making your own coffee. Here is a video on how to make Graham Stephan’s famous 20 cent Iced Coffee:

Now you have $4.80 left to invest in SBUX.

Monthly Services

There are a lot of monthly services people subscribe to. Netflix, Spotify and Amazon Prime are ones that I personally have. Now let’s use Netflix (NFLX) as an example of opportunity cost. Suppose instead of paying $16 a month for premium netflix I instead invested $16 a month into NFLX. This would convert me from a consumer of NFLX to an owner of NFLX. If I did this, then here is what I would have ended up with:

This is calculated by investing $16 a month into NFLX.

Note that at the 5 year mark you could sell off your NFLX shares to pay for 11.5 years of Netflix. Another way you could look at this is if you had just bought NFLX as you were paying for Netflix your NFLX shares would have paid for you to watch Netflix. This illustrates the difference between being a NFLX consumer vs NFLX owner. Another interesting note is that owning stock for a service you consume is a good way to hedge against price hikes. When Netflix raised their price from $14 to $16 they essentially cost consumers $2 more dollars per month, but on the flip end they are also bringing in $2 more per month as revenue, which investors will notice and increase the value of NFLX. This means that if you owned NFLX pre-price change you would have seen the appreciations post-price change, which help to offset the increase in price. Again this is another benefit of being an owner. It’s almost like money moved from your left pocket to your right pocket.

Large Lifestyle Purchases

So far I have covered something that is purchased daily (coffee) and also services that are purchased monthly (Netflix, Spotify, Amazon, etc.). Now I want to cover large fancy purchases that are done usually once a year or once every several years. These products mainly serve to help you live a certain lifestyle and you want them, since companies with billion dollar marketing teams have convinced you that you absolutely need them. I am clubbing items like an IPhone 11 Pro, Tesla Model 3, and Louis Vuitton in this category. Disclaimer … I have a Pixel 4 XL and over 20 sneakers, so I am also guilty of spending on this category. With that out of the way let’s jump to the hot trend lately of owning a Tesla Model 3 (I really want one). The version I want (long range + full self driving) leases for $608 a month, which is great, since you could dollar cost average the same amount in TSLA stock like so:

This was derived by putting $608 a month (the lease amount) into TSLA every month. The first interesting thing to note is that the 1 year lease on a Tesla Model 3 costs $7,296 nominally, but $19,026 in opportunity costs, which means the hidden opportunity costs were 2.5x the nominal costs. At the 5 year mark you could buy a model 3 in cash with the $65,828 in gains you made on TSLA. The 10 year marks is mainly there to illustrate a point rather than to make a sound argument, since most people would not be investing $608 a month on a stock just because they like the product that company makes.

Afterwards

I will admit that the math has plenty of fallacies, since it uses survivorship bias and cherry picking, which is most evident in the Tesla Model 3 example. The direction is that everyone wants a Tesla Model 3 now, since they have been so successful with their marketing and production, but you could have easily decided to purchase a Nissan 5 years ago whose stock has done horribly in the same time frame. I think 7% compound interest is a much more fair estimate for long term opportunity cost, since that is what the S&P 500 has been doing for the last 50ish years. I also am not trying to say that you shouldn’t pay for things like Netflix and IPhone 11s (I pay for them), since the value of those items to you are highly personal and it’s only human to want nice things that you work hard far. I think a safe hedge in these situations is to invest a dollar for every dollar you spend, which will guarantee that you save and invest 50% of your income. Ideally if you keep up the habit of investing money your investments should eventually pay for your purchases, which is demonstrated in my example of using SBUX dividends to pay for Starbucks coffee. Another clarification is I am not pushing for people to balance their portfolios based on their spending habits. As funny as it would be to have a 33% real estate portfolio just because your rent is 33% of your monthly spend, that portfolio probably isn’t diversified and tracking that index would be a nightmare. I am also not pushing for investing in companies just because you consume their products. Making a great product is one thing, but bringing that product to consumers at scale, and with a profit margin is another thing.

At the end of the day this blog post is just trying to get people to think about the opportunity cost of being a consumer rather than an owner of production. It should help you get a better idea for what the true cost of something you are purchasing is. Now hopefully you are motivated to purchase income generating assests now that you know the opportunity costs of income consuming liabilities.

Discussion

Contact Me

Email: bschong2@illinois.edu