5 thoughts on “What’s the right way to think about cost?”

  1. Posted 05/02/2015 at 14:57 | Permalink

    Here is the definition of ‘opportunity cost’ that I used in my 1987 text book ‘Essential Management Accounting’: “The hypothetical revenue or other benefit that might have been obtained by the ‘next best’ alternative course of action, which was foregone in favour of the course actually taken.” Perhaps the best practical example is the discount rate to be used in discounted cash flow calculations for capital projects. It should represent the expected rate of return that could be earned on an equivalent-risk project. It is very important to remember that we are talking here about hypothetical amounts that may well be subject to a large margin of error. NB: I am an accountant not an economist.

  2. Posted 06/02/2015 at 15:17 | Permalink

    It is an interesting characteristic of Economics that the most fundamental concepts can give rise to a fair amount of debate and confusion. The distinction between an opportunity cost notion based upon ‘net’ or surplus concepts and a notion that sticks to ‘gross’ measures of the alternatives sacrificed is a useful clarification. Anthony Evans does not actually say what his answer to the original question would be – but presumably (and in spite of Friedman’s famous dictum) there is such a thing as a ‘free’ Radiohead’ concert, at least there is if the tickets are untradable. The ‘gross’ private opportunity cost is actually zero. Of course, with trade forbidden, there is a hidden social opportunity cost – what another person, implicitly displaced by the ticket winner, might have been prepared to pay. Suppose, instead, that a market is permitted and that Radiohead tickets can be traded there for $60. I suspect that if the question were reformulated in this way many economists (including those from GMU) would have no trouble in saying that the private and social opportunity cost of attending the Radiohead concert using the ‘free’ ticket was $60 – thereby implicitly favouring Anthony Evans’ or Tyler Cowen’s ‘gross’ conception of opportunity cost.

  3. Posted 06/02/2015 at 19:58 | Permalink

    The Tim Harford/Ferraro and Taylor “answers” are not simply confusing “gross” and “net”
    concepts (of opportunity cost); it is rather that they are confusing entirely the elements of an event
    with the opportunity cost (total value of forsaken alternatives) involved in realizing an
    event.

    As the late, great, Armen Alchian explained,* in his locus classicus on the topic of ‘Cost’,
    some 37 years ago, a fundamental distinction must be made… ‘between (a) undesirable attributes
    inherent in some event’ [in the example of Harford, the £40 new/extra ticket money that would have to be
    shucked out to attend the Gaga concert]; ‘and (b) the highest-valued forsaken option necessary
    to realize that event…’ [which Harford reports as a willing-to-pay valuation of £50].
    Clearly the opportunity cost of seeing Radiohead on this night, and not Lady Gaga,
    is –according to Alchian’s classic treatment of this notion –£50, and not £10!

    (I note in parenthesis that if Tim Harford believes that it it is possible to get Lady Gaga Concert
    tickets for £40 then he is also badly mistaken about the market realities in this arena!).

    *A.Alchian, ‘Cost’, International Encyclopaedia of the Social Sciences, Macmillan, New York, and
    the Free Press, 1968, pp.404-14.

  4. Posted 09/02/2015 at 15:23 | Permalink

    Opportunity cost should be defined, net or gross, consistently with the needs of making correct choices. That in turn requires a full specification of the consequences, financial and/or psychic, of each alternative.

    The concert example is not specified fully. The opportunity cost of Radiohead/Clapton is the forgone alternative of the utility value of Gaga/Dylan (50) minus its financial cost (40) which indeed makes it 10. But neither that nor any of the other possible measures help you to choose correctly between the two events, as the utility of attending Radiohead/Clapton is missing. The choice here is between the net value of Gaga/Dylan (10) and the equivalent net value of Radiohead/Clapton. If e.g. attending that brought a ‘willing-to- pay’ value of only 5, and at zero financial cost also a net value of 5, paying to attend Gaga/Dylan with a net value of 10 would be the better option.

    Now, as well as defining opportunity costs, we can also define, with Emily Chamlee-Wright, the net benefit (or cost) of a particular decision. In this case the decision to attend Radiohead/Clapton would have a net benefit of 5 minus opportunity cost of 10, i.e. a net cost of 5, reflecting the fact that it would be the wrong decision. Conversely the opportunity cost of Gaga/Dylan would be a forgone net value of 5, giving it a positive net benefit of 5, as the better option.

    If on the other hand you could sell the Radiohead/Clapton admission for 60, but the utility value of attending to you were 70, you would then be undecided between two alternatives, each with a net value of 10 !

    In the banknote example the alternatives are defined gross (or at least with an implied cost of 0 for acquiring the notes). So the opportunity cost of choosing the £ 20 note is indeed £ 50, which again means a net cost of £ 30 for choosing the £ 20 note, as choosing the £ 50 note is clearly the better option.

    In the projects example the alternatives are in terms of profit, i.e. again in net terms, so the opportunity cost of choosing project 2 is 200, giving a net cost of 50 for the (wrong) choice of project 2.

    The discount rate example is another case of comparing net returns, each having an opportunity cost represented by the net return of the best of the remaining alternatives.

  5. Posted 10/02/2015 at 17:22 | Permalink

    I concur entirely with Dr Zafiris’s lucid and definitive exposition of the logic of the decision analysis that
    may be applied to the (hypothetical) examples referred to in the foregoing discussion.
    However, it is very pertinent to note also that this discussion has not been about choice analysis in general,
    but (more narrowly) about the definition and application of the concept of opportunity cost (which is one
    — but only one — element in choice analysis).
    Moreover, in his original FT article on this latter matter, Tim Harford himself gives examples of
    opportunity cost as follows: ‘Will I give a talk to some students, and therefore not read a bedtime
    story to my son? Will I participate in a panel discussion instead of having a conversation over
    dinner with my wife?’
    In these examples — provided by himself — Tim Harford is clearly applying the concept of opportunity cost
    in the “gross” sense (favoured also by me, the late Armen Alchian, and Professor Tyler Cowen
    of GMU).
    However, in a footnoted answer to his earlier “Radiohead & Lady Gaga” question, he then switches
    suddenly to a “net” approach to the concept of opportunity costs: and which is clearly at variance
    with his earlier exposition.
    The (salutory) conclusion must be that it is vitally important, in utilizing (complex) economic
    concepts such opportunity cost, to define one’s terms very clearly — and then to stick to these
    consistently — if confusion is to be avoided.
    [I must add, as a matter of fairness, that Tim Harford has generally been (in his books and columns) an absolutely outstanding — and consistent! — expositor of the economic way of thinking].

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