I’m still redrafting the opening section of my book, on the concept of opportunity cost. Some applications to specific problems coming soon, I promise. In the meantime, comments and criticism, including editorial corrections and nitpicks, much appreciated.
What is opportunity cost?
Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.
Benjamin Franklin, From his Advice to a Young Tradesman from an Old One” (1746)
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
Robert Frost, The Road Not Taken, 1916
Economists are famous for disagreeing among themselves. Keynesians argue with monetarists about fiscal policy. Members of the Chicago School, including a string of Nobel Memorial Prizewinners1, advocates unfettered free markets, while the case for government intervention in the economy is championed by economists such as Paul Krugman, Amartya Sen and Joseph Stiglitz, all of whom have also been awarded the Prize. As George Bernard Shaw is supposed to have observed, ‘If all the economists in the world were laid end to end, they still wouldn’t reach a conclusion.’
And yet, there is an economic way of thinking that separates any serious economist, regardless of their views on policy, from just about anyone who has not studied economics. The centrepiece of this way of thinking is the concept of opportunity cost. This key idea comes up in the first few weeks of any Economics 101 course, and the definition is easy enough to memorise and restate. Learning to think in terms of opportunity cost takes a lot longer, and many students (including some who go on to become professional economists) never do so.
On the other hand, some people, such as Benjamin Franklin get the idea without any formal training. Franklin’s observation, cited above, that ‘time is money’ has become such a truism that it is often taken to be a traditional proverb rather than the acute observation it was when he made it. Franklin’s explanation points to a far broader point, which forms the basis of the central idea in economics: opportunity cost.
The idea of opportunity cost is inseparably bound up with choice. When we make a choice between alternatives choosing one implies forgoing the other. To paraphrase Robert Frost, the opportunity cost of walking down one road is whatever would have been found on the road not taken. It is this road not travelled, and not any monetary measure, that is most properly regarded as the cost of our choice.
To sum up:
The opportunity cost of anything of value is what you must give up to get it.
This is an idea that seems simple enough when it is first presented, but turns out to be unexpectedly subtle. The lesson of opportunity cost is easy to state, but hard to learn. A large part of any good course in introductory economics consists of attempts to lead students to an understanding of the idea.
Let’s consider some examples, starting with some simple (in fact, simplistic) textbook cases. For people who are largely self-sufficient producers, or who trade mainly through barter, opportunity cost can be described in simple terms. This is why introductory economics courses spend so much time worrying about Robinson Crusoe, alone on his island, or engaged in barter transactions with Friday.
If Crusoe spends a day fishing, when the best alternative was to pick coconuts, the opportunity cost of the fish he eats for dinner is the coconut he might have enjoyed if he had spent the day foraging on land instead.
Alternatively, perhaps, Crusoe might have traded his fish to Friday in return for, say, some roast goat. If the trade goes ahead, then Crusoe’s opportunity cost for his goat dinner is the fish he traded. For Friday, the reverse is true. He gets fish for dinner, and the opportunity cost is the goat.
Of course, these examples are oversimplified, and conceal a range of complexities. A couple are worth mentioning straight away. First, Crusoe can’t know for sure what will happen if he goes foraging for coconuts instead of fishing. The problem of uncertainty is inescapable and, often, intractable. Second, in discussing barter, we haven’t said how Crusoe comes to have the fish, and Friday the goat. We’ll look at both of these issues, and the complexities they raise, later on.
Introducing money complicates the problem even more, and provides plenty of opportunities for fallacious reasoning. The lesson of opportunity cost is that, contrary to the popular view, economics is not ‘all about money’. In fact, the lesson of opportunity cost is harder to learn, the more accustomed you are to thinking about costs and benefits in monetary terms. The principle of opportunity cost is relevant to decisions of all kinds, whether or not there is any monetary cost associated with those decisions.
Sometimes, as we will see, the money price of a good or service is a good measure of its opportunity cost. But very often, as Franklin points out, it is not. The sixpence spent on idle diversion is only part of the opportunity cost of a day off. And even adding the foregone earnings of five shillings may not capture the entire cost. Perhaps the hard working tradesman might have built up goodwill, leading to future demand for his services; this is also part of the opportunity cost.
Opportunity cost is equally relevant to public policy. This is obvious in relation to decisions to provide some particular good or service to the public. In making such a decision, governments forgo opportunities, including alternative expenditure items, cuts in taxation or reductions in public debt (allowing for higher spending in the future). The opportunity cost of a particular item of public expenditure is the value of the best available alternative.
Sometimes, the way in which choices are presented makes it appear that an attractive good can be obtained at no cost. However, a careful consideration of the alternatives usually shows that there is an opportunity cost involved. As we go on, we will see numerous examples of this.
1 The Economics Prize is not one of the original Nobel Prizes, and its full name is The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Philip Mirowski has some interesting remarks on how the prize came into existence http://ineteconomics.org/video/30-ways-be-economist/philip-mirowski-why-there-nobel-memorial-prize-economics
The idea of opportunity cost*
The idea of opportunity cost is a natural consequence of modernity. In a traditional society, most economic decisions are made on the basis of custom, or of fixed obligations (what Marx called ‘motley feudal ties’). The central idea of tradition is to do whatever has been done before. In a modern society, we are faced with new choices all the time, regarding how to spend our household income, how to manage the business of production and how to determine public policy.
We have already seen what may be the first presentation of the idea of opportunity cost, due to Benjamin Franklin. Franklin presented the idea as a piece of practical wisdom, naturally applicable in a modern commercial society, and particularly for the ‘tradesman’ (the term then encompassed shopkeepers as well as self-employed craftsmen) to whom his advice was addressed. But it is equally applicable to anyone making the complex choices entailed by modern life.
The first economic theorist to use the idea of opportunity cost (though not the name) was David Ricardo. Ricardo’s theory of comparative advantage in trade (discussed in more detail later) marked a substantial advance on the assumption that trade was determined by differences in the labor time required for the production of goods in different countries. As Ricardo observed, what mattered was the opportunity cost of producing one good, expressed in terms of the other.
Frederic Bastiat was the first to deploy the idea of opportunity cost (though not the name) as a polemical weapon. Bastiat demolished spurious arguments for a variety of proposals to assist particular industry by pointing out that the proponents had focused on the benefits of the path they proposed without taking account of the opportunity costs of the (unseen) path not taken.
Both Ricardo and Bastiat are well-known names in the history of economic thought. The same cannot be said of Friedrich von Wieser, the Austrian economist who coined the term ‘opportunity cost’, (German Opportunitätskosten) along with the equally notable term ‘marginal utility’. Along with Carl Menger, and Eugen Bohm von Bawerk, Wieser was one of the founders of the ‘Austrian School’ of economics.
For Wieser, the concept of opportunity cost was applicable, not only to decisions made in markets but also to the distribution of wealth and resources for the community as a whole. A highly unequal distribution of wealth means that the luxury consumption of the rich takes precedence over the basic needs of the poor. As Wieser sharply observes
It is therefore the distribution of wealth that decides what will be produced, and leads to a consumer of a more anti-economic variety: a consumer wastes on unnecessary, guilty enjoyment that which could have served to heal the wounds of poverty.
Wieser used this idea to justify a progressive income tax.
The idea of opportunity cost was brought into the mainstream of economics by Austrian and Austrian-influenced economists, most notably FA Hayek, Ludwig von Mises and Lionel Robbins. Unfortunately, all three were dogmatic advocates of the free market, who stripped Wieser’s idea of its egalitarian implications
Mainstream economists largely accepted Robbins’ dictum that interpersonal comparisons of wellbeing should be rejected as ‘unscientific’, and sought to rebuild welfare economics without reference to such concepts as marginal utility (another term coined by Wieser). By the time theorists such as Peter Diamond and James Mirrlees returned to the problem of optimal tax in the 1970s, the link to Wieser’s work and to the concept of opportunity cost was lost.
Meanwhile, rather than applying the opportunity cost concept to the actual problems of economics, Wieser’s students Hayek and Mises pursued a far less fruitful aspect of his work: the sterile 19th century controversy over the “theory of value”. By subordinating economic analysis to dogmatic ‘market fundamentalism’, Hayek and Mises drove the Austrian school of economics into a blind alley from which it has never escaped.2
1 The Economics Prize is not one of the original Nobel Prizes, and its full name is The Bank of Sweden Prize in in Economic Sciences in Memory of Alfred Nobel. Philip Mirowski has some interesting remarks on how the prize came into existence http://ineteconomics.org/video/30-ways-be-economist/philip-mirowski-why-there-nobel-memorial-prize-economics
2 As I observed in my book Zombie Economics, the same is true of another innovation of the Austrian School, their business cycle theory, based on bubbles and busts in investment. The model implied that governments could potentially stabilise the cycle with beneficial effects, but Hayek and Mises were unwilling to accept the implications of their own theory. Instead, they advocated a contractionist response to the Great Depression, which had disastrous results wherever it was implemented.