A couple of days ago, I wrote about prices, profits, and losses in the context of the Styrofoam-or-paper debate. Yesterday, we covered cost and supply in econ 100. Here is an email I sent to my students this morning that addresses the question of measuring costs using dollars and cents. One of the best treatments of the cost concept is James Buchanan’s Cost and Choice. Here’s the email:
Here are a few quick thoughts on the use of dollars and cents to measure opportunity cost. They’re a little beyond what we’re doing this semester, they won’t be on any of the tests, and they will likely reappear in more formal fashion in intermediate microeconomics, but I thought that some of you might be interested:
When we talk about “cost,” we’re talking about something subjective: a cost is the next-best opportunity that you have to forgo in order to do something. Since cost is subjective, how do we get away with expressing cost in terms of money?
Using dollars and cents to approximate costs is actually more sound than it might appear to be at first. The market’s process of buying and selling generates market prices for things like corn, potatoes, textbooks—and labor of different kinds.
We hypothesized yesterday that if the going you are each giving up the opportunity to work for wages in order to come to class. If you could have earned $8/hour, then going to class for 75 minutes cost you $10 in foregone wages.
You might respond “but what if my next best opportunity is sleep, studying for another class, or playing video games rather than working? How do you get away with the ‘$10 cost’ statement?”
That’s a good question, and it illustrates that the cost we are estimating is at best a minimum cost: we know that the cost to you of going to class is at least $10 even if there are a lot of activities between “going to class” and “working for wages” that you prefer to “working for wages.” Since we can observe market prices for different types of labor, and since most labor markets are extremely competitive, we can be pretty sure that going to class costs you at least $10. Suppose you rank the different uses of the 75 minutes between 2 and 3:15 as follows:
1. Go to Econ 100 (I’m flattered)
2. Sleep
3. Play video games
4. Watch paint dry
5. Work for $10
Value is subjective, so we can’t assign numbers that tell us anything about how much you value options 1-4; i.e., we can’t say that “Econ 100 gives you two gallons of happy while sleep only gives you 1.5 gallons of happy.” We can, however, observe the market price of labor and say that by going to class, you are giving up—at the very least—the opportunity to earn $10.
As this course is an introduction to economics, there are all sorts of interesting (?) details we will have to skip over. A few weeks ago, I sent you links to Ludwig von Mises’s Human Action and Murray Rothbard’s Man, Economy, and State, which provide unique and somewhat non-traditional approaches to economic thinking. Stephen Landsburg’s The Armchair Economist (which isn’t free online, unfortunately) provides a very good discussion of basic economics and might be a worthy addition to your nightstand.
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Since each person has 24 hours in a day, does this mean that every hour of sleep has an opportunity cost of $10? But since nobody can go without sleep indefinitely, doesn’t this mean that some of those hours of sleep aren’t an opportunity cost, but are the opposite: they enable one to work at all during the other hours. Taking this further, even if one slept sufficiently and worked every waking hour, one would become mentally worn out (unless the work was fulfilling in itself), so there are other things one must spend one’s time on as well in order to have the mental state to be able to work, similar to needing sleep. I’m just interested in how this factors in, or whether I’m missing the point of these calculations.
BTW, a typo or something: “We hypothesized yesterday that if the going you are each giving up the opportunity to work for wages in order to come to class.” I’m guessing that this was going to say “if the going rate was $10 per hour, then coming to class costs you $10″, but got expanded to two sentences.
Shay,
It is all about the marginal hour of work. Working 40 hours per week you are getting enough sleep and regeneration time etc., so if you are asked to stay late one day you would probably be willing to so so for $10 per hour. In other words, you would give up an hour of sleep/leisure for $10.
If you are working 60 hours per week and asked to stay an extra hour you might do so only if you were promised extra pay, say $15 per hour. As you increased your working time your opportunity cost increased, since sleep/leisure became comparatively more valuable to you. Even if you worked 100 hours per week there would probably be a price that would convince you to stay one more hour, but that price would be much higher since that extra hour of sleep (your opportunity cost) would be worth that much more to you.
Thus it is the marginal opportunity cost that influences you behavior, just as it is the marginal utility of another car or another bottle of pop that will determine the price you are willing to pay for those things.
I am no expert, but I hope that helps answer your question?
I know what I am going to say will sound like drivel.
But I end up thinking that life is the opportunity to takeover your soul and if you fail to accomplish that, well, you are not going to bring those $10 bills with you on the other side.
What I want is the water in the golden bowl. Yeah, I know, I am not a down to earth practical man, LOL !
The true American dream is to be independently wealthy. It’s not to have a house and white picket fence… that is just a external image of what it is.
Independently wealthy means that you are able to work on your own terms and be the your own ruler. To live paycheck to paycheck means your dependent on somebody else and, worse, if your deeply in debt you’ve just sold your future in exchange for consumer goods. Essentially your a slave to the lender.
It does not mean your rich or that you can get away with not working for years… but what it means is that you have the luxury of choice. If you don’t like your circumstances, you can just walk away. Not owe anybody anything and yet still be able to live up to your responsibilities.
Independence. Liberty. Freedom. Ruler of yourself. Fantastic stuff.
Yes, I think one can be completely satisfied with almost any situation (assuming basic needs are met). It’s whether the thing limiting improvement of one’s situation is natural or artificial. Natural is about the limits of what one is capable of, resources available, etc. Artificial is where someone else is in an asymmetrical power relationshop with you, lording over you in some way. In that case, I don’t think one can be completely satisfied, even if one has a huge house, because one always knows that one is subservient to the one exerting power over you.
I don’t quite agree.
Yes, you can conclude that your top three choices are preferred to option 4, but option 4 is not “receive 10 dollars”, it is “work to get 10 dollars”.
In other words, by giving up option 4, you are foregoing 10 dollars, but you are also dispensing from a special effort (work). So option 4 is worth less than 10 dollars. We don’t know how much less.
Excellent post — and thank you for the link to the Online Library of Liberty, of which I was previously unaware.
A bit surprised that nobody has posted a comment here suggesting the use of the thought-experiment model, to replace the “gallons of happy” concept used above. (I’d be shocked if nobody mentioned it in e-mail replies or classroom discussion.)
It might be a bit tough to accurately and consistently envision units of “happy” in gallons (though the concept of doing so in, say, microScarlettJohanssons or milliRyanReynoldses might be… attractive?)
But if you simply ask people, “how many $ would you pay to be able to / have to be paid to get you to” do activity X for time Y — and then double-check / tweak the values arrived at by direct comparisons of pairs of actions (“you say you’d pay yay much to sleep an hour, and yo much for an hour of World-o-Warcraft; you really like this one that much more/less than that one, if those are the only options?”) — I’d bet you’d get a very good first-order approximation.
As a further note, as an exercise in identifying, and ranking, what your personal values really are — as opposed to what you think they are, or might like them to be — this method is killer.
A very powerful learning experience, and results are often surprising and/or disturbing.
(If you try it at home, be sure to use protective gear, and absolutely do not engage in this with your significant-other without thinking thru certain potential responses in advance very, very carefully.)
How do subsidies, social programs, welfare, entitlements, etc. affect opportunity cost? What happens to the value of money? Maybe you could illustrate / give an example.
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