Tuesday, 26 June 2018

Tim Harford on opportunity cost

One of the first concepts I cover in my ECONS101 and ECONS102 classes is opportunity cost. It is also one of the most misunderstood concepts in economics. The inability to recognise that every choice comes with an associated cost (economists are fond of the phrase, "there is no free lunch") plagues public policy and business decision-making. And yet, the idea that when you choose something you are giving up something else that you could have chosen instead, should be intuitively obvious to anyone who has ever made a decision.

Tim Harford recently covered opportunity costs, in his usual easy-to-read style:
The principle of an opportunity cost does not at first glance seem hard to understand. If you spend half an hour noodling around on Twitter, when you would otherwise have been reading a book, the lost book-reading time is the opportunity cost of the tweeting. If you decide to buy a fancy belt for £100 instead of a cheaper one for £20, the opportunity cost is the £80 shirt you could otherwise have bought. Everything has a cost: whatever you were going to do instead, but couldn’t.
We should weigh opportunity costs with some care, mentally balancing any expenditure of time or money against what we might do or buy instead. However, observation suggests that this is not how we really behave. Ponder the agonised indecision of a customer in a stereo shop, unable to decide between a $1,000 Pioneer and a $700 Sony. The salesman asks, “Would you rather have the Pioneer, or the Sony and $300 worth of CDs?”, and the indecision evaporates. The Sony it is.
And Harford also explains why understanding opportunity costs is consequential:
Drawing our attention to opportunity costs, no matter how obvious, may change our decisions. The notorious falsehood on the campaign bus used by Vote Leave during the 2016 referendum campaign was well-crafted in this respect: not only could the UK save money by leaving the EU, we were told, but that money could then be spent on the National Health Service.
One could certainly debate the premise — indeed, the referendum campaign sometimes seemed to debate little else — but the conclusion was rock solid: if you have more money to spend, you can indeed spend more money on the NHS. (Just another way in which that bus was a display of marketing genius.)
We would make better decisions if we reminded ourselves about opportunity costs more often and more explicitly. Nowhere is this more true than in the case of time. Many of us have to deal with frequent claims on our time — “Can we meet for coffee so that I can pick your brains?” — and find it hard to say no. Explicitly considering the opportunity cost can help: if I meet for coffee I’ll have to work an hour later, and that means I won’t be able to read my son a story before bedtime.
Notice that in the latter example, the opportunity cost cannot easily be measured in monetary terms (how much is reading your son a story before bedtime worth?). However, in terms of impact on our satisfaction or happiness (what economists term 'utility'), we can make a comparison between these different options. You might also want to consider the costs you are imposing on others (whether monetary or otherwise) - economists refer to this as having social preferences (altruism is one example of social preferences). If your decisions affect others (which many decisions do), then others may face opportunity costs from your choices.

The next time you are making a decision, whether small or large, consider what is being given up to get the option you choose. It might not be measured in monetary terms, but there will always be a cost. You'll then make better decisions, or at least decisions that leave you happier overall.

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