What’s the right way to think about cost?
‘Imagine that you have a free ticket (which you cannot resell) to see Radiohead performing. But, by staggering coincidence, you could also go to see Lady Gaga – there are tickets on sale for £40. You’d be willing to pay £50 to see Lady Gaga on any given night, and her concert is the best alternative to seeing Radiohead. Assume there are no other costs of seeing either gig. What is the opportunity cost of seeing Radiohead? (a) £0, (b), £10, (c) £40, or (d) £50.
He provides an answer to the question at the end of his article. The example is based on an academic article by Paul Ferraro and Laura Taylor. Their version is the following:
‘You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50.’
In a New York Times article, in 2005, Robert Frank provided the following answer: The opportunity cost of seeing Clapton is the total value of everything you must sacrifice to attend his concert – namely, the value to you of attending the Dylan concert. That value is $10 – the difference between the $50 that seeing his concert would be worth to you and the $40 you would have to pay for a ticket. So the unambiguously correct answer to the question is $10. Yet only 21.6 per cent of the professional economists surveyed chose that answer, a smaller percentage than if they had chosen randomly.
Writing at the time, Alex Tabarrok called this a ‘professional embarrassment’, and reassured readers that ‘if you really want to learn economics come to GMU [George Mason University]. I guarantee that your professors understand opportunity cost’.
The reason I noticed this is because I learnt economics at GMU, and have recently published a textbook on Managerial Economics called Markets for Managers. The second chapter is called ‘Cost and Choice’ and I use the following example:
Imagine that you are given a choice between three banknotes:
What is the cost of choosing the £20 note?
The answer I provide is £50. This is in conflict with Harford, Frank, and Tabarrok. Am I wrong? Do I not understand cost?
The first point to make is that we’re debating the concept of ‘opportunity cost’, and the idea that the cost of an action is what you forgo. Therefore the amount that you pay, or the receipt that you might provide your accountant, are not what economists consider to be costs. But I find it odd that in the above examples cost is defined as the ‘net benefit’. And I’m not the only one.
The example that I used in my textbook is based on the following question from a management training programme that I attended:
You have a choice between three different projects, and these are the associated profits. What is the opportunity cost of choosing project 2?
This prompted an intense discussion amongst participants. Many said that cost is the difference between the value of option 2 ($150), and the value of your next best alternative (i.e. $200). So I think that a plausible answer is $50. And this utilises the same reasoning that would say the cost of seeing Radiohead/Clapton is the difference between the value of that option, and the value of your next best alternative – which is $10.
However, in my classes I define cost as the Next Best Alternative (NBA). I don’t define it as the difference between the value of the action that you choose and the value of the NBA. The latter is an important concept, but it seems to me that we’re jumping to an answer too quickly (or possibly asking the wrong question). At the programme, I was impressed by the contribution of Emily Chamlee-Wright:
‘[Y]our opportunity cost is the value you forgo. It is important to understand the net cost of a particular decision but opportunity cost is an input into that computation, not the solution.’
Indeed in response to the Ferraro & Taylor question, Tyler Cowen said the following:
‘But just as “cost” was a gross term, so does “opportunity cost” stay a gross term, it does not become a net one. Only the word “opportunity” has been added to “cost,” so why leap from gross to net thinking?…
G.L.S. Shackle wrote about a “skein of imagined alternatives.” This captures the “gross” idea properly, and remains subjectivist, but it doesn’t encourage the leap into the mix of net thinking and consumer surplus, which remains a separate concept.’
So for readers of my textbook that would say the answer is £30, I don’t think that’s wrong. But I believe that an answer of £50 is more consistent with how I’ve defined costs in the book, and how we tend to treat them in the real world. The fact that professional economists debate this – and use the same examples almost a decade letter – shows just how rich and important the basic concepts are.
Anthony J. Evans is the author of Market for Managers: A Managerial Economics Primer.