September 25, 2019
Merewyn Groom

When did economics forget the opportunity cost?

People think of financial cost and value as being interchangeable. In economics we also think of the opportunity cost, the alternative decision that we didn't choose. When did we forget that it has value too? 

Economists see themselves as different to accountants, even if the public can’t tell us apart. Every economics student learns that economics differs from accounting, in that we consider both the financial costs and the opportunity costs.

At the BERL Wānanga recently, we considered the concept of value, and it was pointed out that only financial transactions are measured as part of our economic activity. In accounting, a cost is defined by the amount of money required to pay for it. We economists believe this misses the point, money is just a way of keeping track of things. When choosing how to invest, what is important is the benefit you might have got from using that money (and your time and effort) in other ways. This is the opportunity cost.  Despite the importance of opportunity costs in economics, it goes missing when we look at the big picture of our economy.

Confused? Opportunity cost can be defined as “the loss of other alternatives when one alternative is chosen.” The fundamental concept is that for every decision, in business or in life, there were options we didn’t take. If we are rational, then we didn’t choose those other options because they somehow weren’t as good.

Imagine you are at your favourite restaurant. You really like two of their dishes. The problem is, if you order the Nasi Lemak, you won’t get to eat the Mee Goreng. In this case they are priced the same, and you need to eat lunch, so the accounting cost of the $12 lunch special is irrelevant. At issue here is how much you will enjoy one dish over the other. If you go with the Mee Goreng, the opportunity cost is how much you would have enjoyed having the Nasi Lemak.

Perhaps the true price of this lunch is the pain of choosing between two things you love (after all there’s no such thing as a free lunch).

This never happens to me because I know that Nasi Lemak is far superior. Let’s pretend it were possible to put a dollar value on such superiority. If my love of Nasi Lemak is equivalent to $15, and I like Mee Goreng to about $11, we can plot the accounting and opportunity costs on a graph.

$ cost is the money I have to pay, equal in either case. But the enjoyment value might be different for each option.

Hopefully you can see that the money cost of the two meals is the same, but if I get the Mee Goreng I miss out on $4 of enjoyment value. Therefore the cost of not having Nasi Lemak is $4, or put another way it’s the value gained by switching from Mee Goreng to Nasi Lemak.

This concept flows through most of the textbook economics. Students going into their exam would be well reminded to not forget about the opportunity cost.

Value = cost?

When we come to real world economics and decision making today, have we forgotten to include the opportunity cost?

Econ101 taught me that the value of something is determined by the market. What that means is, the price you pay for butter is the value of that butter. But what happens when there is no market? How do we value things that are not bought or sold?

By that logic work by volunteers, cuddles from your mum, popping over to Grandma’s to mow her lawn, none of this has any value. Obviously something is broken with that calculation.

Thinking of value as measured by cost has other problematic challenges, as the concept of economic growth largely comes back to an aggregation of all of these financial costs. Through our desire to measure and track the economy, have economists been transformed into a bunch of eccentric accountants?

Growing up, I was lucky enough to grow up in a household where my mother was able to choose to not participate in paid employment to enable her to spend time with her children. She didn’t get a wage, so the accountants could value this cost as zero.

On the other hand, had she had a job looking after another family, and hired someone to look after us, this would be counted as economic activity.

In reality, this decision was made on the basis that more value would be gained from her looking after our family than she would have gained in full time work. Having mum at home was worth more to my family than the money she would have earned. This is an example of a rational decision to forgo additional income, because the opportunity cost of going out to work was higher than the value of the wage she would have earned.