Monday, October 04, 2010

CUE CARD ECONOMICS: Opportunity Cost

There are plenty of contemporary economic concepts that make no sense—or, worse, serve only to obscure legitimate concepts. “Externalities” is one, an illegitimate concept that serves only to delegitimize a necessary one, in this case: property rights. (Other  equally illegitimate cousins of this anti-concept include “stakeholder theory”—the idea that that a business owes its community, rather then the other way around, and whether anyone in the community has contributed to the business’s success or not—and the phony “free-rider problem” are other related examples of equally shoddy package deals.)

“Opportunity cost” is equally nonsensical.

One of the most common notions in economics, “opportunity cost” is [in Larry Sechrest’s formulation]

_Quote the idea that the cost one must bear when making choices is appropriately measured by the value to the actor of what he or she gives up. If A and B are ranked first and second, respectively, on one’s value scale, then the cost of choosing A is said to be B, the next best alternative.

But once one observes that this is a ‘B’ one hasn’t even got, one realises that this is a cost that hasn’t, and won’t, be paid—and we end up treating what is not even a potential loss as a real one. Which leads to the realisation that “opportunity costs” are an exercise in unreality.

To see how foolish this anti-concept is, just imagine I’m evaluating my year’s share trading. In January, let’s imagine I considered plunging heavily on two hypothetical stocks, one of which rose to $20 and one of which rose to $30. If I had bought the first and remained uninformed about “opportunity costs,” I would be under the “illusion” I had made a profit. Yet if I had read the latest textbooks, I would be made “aware” that instead I’d made a dreadful loss, and rather than uncorking champagne I should instead contemplate throwing myself off the nearest tall building!

The absurdity is real. The”loss” is not. Neither is the concept of “opportunity cost.” Says Reisman, those who insist that the doctrine of opportunity cost is valid

_Quoteconfuse the alternative opportunities whose competition in bidding gives rise to the money costs with the phenomenon of cost itself, and thereafter ignore the necessity of a money outlay actually being present. In other words, they....confuse the cause with the effect.

And the potential with the actual.

So stop worrying about a non-existent cost, or “you can wind up needlessly worrying about money that you never made.”

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27 Comments:

Blogger Greig McGill said...

Hrm. I've always thought OC was an illustration of the Broken Window Fallacy.

So long as one measures both "opportunities" against the yardstick of reality (that is, use known values and certainties, not "might have beens"), I fail to see why it's not valid?

10/04/2010 02:27:00 pm  
Anonymous Anonymous said...

I make the same error as Grieg and call it dead-weight cost.

10/04/2010 02:35:00 pm  
Anonymous Dolf said...

I must have misunderstood OC since economics 101 then.

I've always had it as the (very real) sacrifice I make when I spend money on something. For example, if my salary can buy a nice boat, or some food, but not both, the sacrifice of going hungry on a nice boat is very real.

As Greig said, it's always been the main way I understood and explained the broken window fallacy.

10/04/2010 02:47:00 pm  
Blogger PC said...

"Opportunity cost" isn't a cost. It's just something that hasn't happened.

You don't need "opportunity cost" to explain the Broken Window Fallacy. All you need to say is that the baker is financially better off if he doesn't have to pay twice over for the same window--and if he didn't have to, he would have the money cost of the suit still in his pocket instead of the glazer's.

But let's not confuse a money cost with a made-up cost.

10/04/2010 02:53:00 pm  
Blogger PC said...

@Dolf: But instead of buying the boat I could instead have flown to Hawaii for a month, drunk champagne for a week, or booked Lisa Lewis for the night.

That I'm now not suffering from sunburn, a hangover or a rash is not a cost. It's a bonus. :-)

But it's a "bonus" that's no more real than the non-existent "cost" of not buying them.

But don't worry. It's not the only thing you were taught in Econ 101 that doesn't pass muster. ;^)

10/04/2010 03:05:00 pm  
Blogger Ruth said...

As I see it, opportunity cost is always there, as the cost of the next best alternative.

In terms of investment, holding stock that is unlikely to move is costing me the opportunity of purchasing better stock.

Simple.

10/04/2010 03:08:00 pm  
Blogger Ruth said...

Addendum - quite a few loser type folk love to say "My investment has gone from $50 to $1 but has cost me nothing in opportunity cost because I haven't sold it."

Hope this isn't what you are saying here ;-)

10/04/2010 03:10:00 pm  
Blogger Owen McShane said...

I am not sure the notion of opportunity cost has no utility. If the Auckland Council spend hundreds of millions on a rail connection to the Airport which cannot even pay the cost of capital then it not only destroys wealth but has lost the benefits that would have accrued by improving the road network and providing a useful road link to the airport actually able to carry freight as well as people.

But closer to home. When people are wondering how much to discount their house in a falling market, they not only need to figure how much their mortgage costs in interest every year – they also have to take into account what they could do with any cash they might find in their pocket. For example they might be able to build a decent office with decent equipment and work from home.

As long as the house sits it is both consuming income in interest payments but also preventing the owner from improving their general economic wellbeing by investing their own money rather than leaving it controlled by the bank.

10/04/2010 03:18:00 pm  
Blogger PC said...

@Ruth: No, it's not what I'm saying--not as long as you don't start imputing to yourself profits you haven't made.

@Owen: In that case (where not even a small profit was made) you can simply say we're all worse off because the council has made an actual loss on money that could have made an actual profit.

You don't need to thrown in a fictionally imputed "profit" to make it sound more convincing. A loss is a loss.

Everyone is entitled to weigh up their alternatives, and should do, but they shouldn't fool themselves that failure to take up one of them ipso facto has imposed on them an imaginary cost.

10/04/2010 03:31:00 pm  
Blogger PC said...

It's also quite right to say it's better to make a bigger financial profit than a smaller one. But a profit is a profit--however small.

Only in an economics textbook does a profit, however small, become a "cost."

10/04/2010 03:35:00 pm  
Anonymous Michael said...

I've always had it as the (very real) sacrifice I make when I spend money on something. For example, if my salary can buy a nice boat, or some food, but not both, the sacrifice of going hungry on a nice boat is very real.

your not meant to view it as a sacrifice. Thats the wrong way to look at it.

It is simply the cost of A , in terms of what you could have gained from choosing B instead. By definition it assumes that A is of SOME value and if the benefit of A is higher than the oppurtunity cost of B, you should probably choose A.

Or if the opportunity cost of B is greater than the benefit of choosing A, well you dont choose A then.

it certainly isn't an anti-concept.

10/04/2010 03:54:00 pm  
Anonymous Riko said...

One thing which always intrigues me about Keynesian Theory is the fact that there is absolutely no rationale behind its concepts, let alone that of an incorrect nature. For instance, why only one opportunity cost and not two, or more, or all of the alternative applications of the money in question.

Also, as Economic Profit = Accounting Profit - Opportunity Cost. ----> if one invests in an avenue which yields less return than expected and/or the original opportunity cost yields more than expected. Say, the avenue in which the money was placed gives a return of 10 million dollars, where as the alternative application actually would have given a 11 million dollar return, then according to Keynesian Theory, one has made an economic loss equal to 1 million dollars. Hmmm??

An opportunity cost is precisely as its namesake entails, an opportunity. However, it is one which is never actioned and remains only an opportunity, thus it cannot be counted in reality.

10/04/2010 04:23:00 pm  
Anonymous Dolf said...

PC, You've clarified your position rather well, and you are right, econ 101 taught me little of value.

I was about halfway through typing what I thought was a clever response, when your position made sense to me.

I was looking at OC in the future, but that is merely estimated benefit, using it retroactivley assumes losing a profit that never actually accrued.

10/04/2010 04:40:00 pm  
Blogger Tim Johnston said...

very interesting!

I've always understood OC as consumption vs. investment. So I buy a new car instead of stock, and the profit I would've made is lost profit. Ben Franklin (I think) described lost earnings as a cost/loss. So if you take a day off, it effectively costs you money.

10/04/2010 05:24:00 pm  
Blogger Tim Johnston said...

... but you can always drive yourself mental worrying about what you "could've" bought!

10/04/2010 05:26:00 pm  
Anonymous Trevor said...

Peter, I don't think you quite understand what OC is:

Opportunity costs are about assessing what you are going to do with what you have based on what you know now and realizing that by doing one thing you may give up the ability to do something else, so choose wisely to try to maximize your outcomes with what you do versus what you could have done. The opportunities themselves are what you are trading in in these situations and the opportunities ARE things you had. You didn't have a sports car and a beach house when you had those couple hundred thousand dollars in your pocket, but you did have the opportunity to get one or the other with your money. By choosing the beach house, you get the beach house but you traded in the opportunity to get the fancy sports car in the process.

10/04/2010 06:14:00 pm  
Anonymous Trevor said...

But it's a "bonus" that's no more real than the non-existent "cost" of not buying them.

how are you using the term "non-existent?"

It seems almost like you're trying to use "existence" as referring only to purely physical things. An opportunity cost is not physical per-se. But it is a cost: you are giving up an "opportunity" - which is non-physical, but still a concept. It's like saying punching your best friend in the nose costs you a friendship. Well, a friendship exists, doesn't it? But as a concept, not as a physical object. You're losing an opportunity - i.e., the cost of your action was that opportunity. Or all opportunities that were canceled out.

10/04/2010 06:22:00 pm  
Blogger Paul Walker said...

"If A and B are ranked first and second, respectively, on one’s value scale, then the cost of choosing A is said to be B, the next best alternative. But once one observes that this is a ‘B’ one hasn’t even got, one realises that this is a cost that hasn’t, and won’t, be paid—and we end up treating what is not even a potential loss as a real one."

But it is a cost that is paid, since you haven't gotten B. That's the point.

Simple example: I go to university for a year to study economics and I pay $1000 in fees which is a cost. I could have gotten a job paying $20,000 for that year. I have foregone that job and thus the money I could have earned by going to uni. Thus my total opportunity costs $21,000.

10/04/2010 08:59:00 pm  
Anonymous Deepak said...

How about these 2 scenarios when one chooses to entertain a good looking chic in a bar by buying her drinks (perhaps all night) in the hope that he scores her at the end, versus the other option such as there is an ugly chic (or fat chick) sitting on her own at the other corner of the bar unaccompanied where the chance of scoring her at the end of the night is higher (compared to the good looking chick), with just a smile or even a simple "hello" to her?

Can the scenarios described here be regarded as opportunity OC? Spending lots of money on a good looking chick with low guarantee of taking her home, or shouting just one drink (low cost) to an ugly and fat chick which has more chance?

10/04/2010 09:37:00 pm  
Blogger Paul Walker said...

Deepak: If you get one of the women, you don't get the other. So each is the opportunity cost of the other.

10/04/2010 09:45:00 pm  
Anonymous Trevor said...

Simple example: I go to university for a year to study economics and I pay $1000 in fees which is a cost. I could have gotten a job paying $20,000 for that year. I have foregone that job and thus the money I could have earned by going to uni. Thus my total opportunity costs $21,000.

No it is 20,000. Remember the oppurtunity cost is the benefit of the next best alternative or the value of the next best alternative.
The value of that which is not gained by NOT choosing that alternative.

So if I choose to invest in the stock market, and my only other option is to save it : I lose out on the interest from savings. That is the oppurtunity cost in deciding to invest in the stock market in this case.


So say I could have gained $200 in interest. That is the oppurtunity cost here, $200 in interest.

10/04/2010 09:47:00 pm  
Anonymous Kimble said...

Oh for christs sake.

You keep doing this. You misunderstand an economic concept (in this case, opportunity cost) and then rail against that misunderstanding.

Opportunity cost is crucial to understanding scarcity, choice and efficiency. Opportunity cost does relate to the Broken Window fallacy in that both deal with the "unseen".

Do yourself a favour and google the difference between economic cost and accounting cost. If you want to tear down Opportunity Cost, you need to do better than this.

And how the hell is the idea of externalities "illegitimate"? If you want to frame things in terms of property rights, go ahead, there can still be externalities (which would simply describe the un-priced infringements against an un-related parties property rights). Given your problems with opportunity cost, I doubt you actually understand what externalities really are.

The free-rider problem is not phony either, it actually exists. It may just be that it probably isnt as big a problem as has been made out in the past.

On that, I suspect the real problem you have with the concepts of both externalities and free-riding is that they are often used as an excuse to expand government power. But there are other private solutions to the problems as well. It is stupid to deny a problem exists just because you dont like the most commonly used solution.

10/04/2010 09:53:00 pm  
Blogger Paul Walker said...

Trevor: "No it is 20,000."

No its $21,000 since the $1000 fee is an opportunity cost in and of itself.

10/04/2010 11:09:00 pm  
Blogger Greig McGill said...

Kimble: How can there be "externalities" when there is no vague, nebulous, undefined "external". Every bit of the external would be privately owned, so what you'd have is a very real cost of making use of some other person's property.

Unlike PC though, I don't consider these concepts invalid. "Externalities" as a concept and as a practice most certainly does exist now, and is useful in explaining exactly why well defined and enforced property rights are vital.

This discussion is really interesting though. As Dolf said, it's making me reevaluate completely a lot of core economic theory. The only issue is that I don't think it's changing my view on it that much, maybe just questioning the terminology used and the meaning behind the concepts.

10/05/2010 07:47:00 am  
Anonymous Trevor said...

No its $21,000 since the $1000 fee is an opportunity cost in and of itself.

not really. the OP is the value of the next best alternative which you have forsaken. The $1000 fee is not a "lost oppurtunity" after all.

10/05/2010 09:35:00 am  
Anonymous Kimble said...

Greig it is an EXternality because it is external to the obvious transaction taking place. It is often part of the "unseen" that good economists should recognise.

10/05/2010 11:13:00 am  
Blogger Paul Walker said...

"the OP is the value of the next best alternative which you have forsaken. The $1000 fee is not a "lost oppurtunity" after all."

Yes it is. Given I have spent $1000 on fees this means I have not spent $1000 on something else. Thus there must be an opportunity cost here.

10/05/2010 01:45:00 pm  

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