All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Economic and Accounting Cost
There is no free lunch

Scarcity means we cannot have it all, we must make choices. But how do we make those choices? How can we explain the choices people and businesses make? Economists tend to adopt the approach that choices are rational, when making decisions people and businesses weigh the benefits and the costs and choose actions where the benefits exceed the costs.  As a result economists tend to focus a considerable amount of attention on the concept of cost, one of the inputs into decisions. They also tend to approach cost from a rather unique perspective, one grounded in the concept of scarcity.  If we accept the existence of scarcity, then we realize every choice to do something is also a choice to not do something else. Your choice to study can be looked at as your choice not to party, the choice to attend class can be viewed as a choice not to watch the soaps or catch up on your sleep.

Once you recognize there are two sides to every choice, you can better understand opportunity/economic cost and sunk cost.  As a starter let's look at a simple example - let's look at the choices of Rueben and Raye who are going to pay $7.50 a ticket to see the movie A Funny Thing Happened on the Way to University. Rueben has a $5,000 scholarship at University where he is studying underwater basket weaving. Raye, meanwhile, is a consultant who is paid $100 per hour for advice on dating. What is the cost of the movie for Rueben and Raye?

We could all agree the accounting cost is $7.50, what each will need to pay for the two hour movie. But how much is it really costing them? For Raye, if she could have used the time for consulting, then she would be giving up $200 for two hours of work.  This is what an economist would say you need to add to the ticket price to get the movie's economic cost.  The economic cost of using a scarce resource to achieve something is the cost of not using the resource in its best alternative use. If Raye does not go to the movie she earns $200, and if she goes to the movie she spends $7.50.  The difference in her 'bank account' at the end of the movie would be $207.50 -  what we would call the economic cost of the movie for Raye. 

And then there is Rueben, who expected to enjoy a night away from his studies. Unfortunately for Rueben, he is met by a classmate at the candy counter just after he has paid his $7.50 for the movie. The classmate informs Rueben he just received an e-mail which stated that there will be a test the next day.  Rueben realizes he should study because a bad grade, the one he is likely to get if he does not study tonight, will cause him to lose his scholarship. At this time we would look at the $7.50 as a sunk cost (a past, non recoverable cost that has little to do with the current choice).  For Rueben, once he has paid for the movie and finds out about the exam, the cost of the movie becomes $5,000.  If he goes home to study he keeps his scholarship, but if he stays at the movie he will lose his scholarship of $5,000.  We can only hope that Rueben realizes the true cost of the movie.

To make sure that you have mastered the concept of opportunity cost, try your hand at the following two examples.

Example: The cost of a year of college.

Example: The cost of staying in business

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