My seatmate might have profited from reading Alfred Marshall who called economics "the study of mankind in the ordinary business of life." This was the enterprise of Marshall and Adam Smith and Friedrich Hayek and Milton Friedman: they tried to understand what people do and the implications of their behavior for the society at large.
But my favorite definition of economics is a variant of Marshall's. It comes from a student who heard it from another teacher of hers: economics is the study of how to get the most out of life. I like this because it strikes at the true heart of economics—the choices we make, given that we can't have everything we want. Economics is the study of infinite wants and finite means, the study of constrained choices. This is true for individuals and governments, families and nations. Thomas Sowell said it best: no solutions, only tradeoffs. To get the most out of life, to think like an economist, you have to be know what you're giving up in order to get something else. That's all opportunity cost is:
Opportunity cost is what you have to give up to get something.
What could be more straightforward? If you want something you have to give up something. The idea turns out to be a little subtler than it appears at first glance. Let's look a little more closely.
Milton Friedman used to say that economics is simple. All you have to remember is that demand slopes downward and that nothing's free. The hard part is applying those two simple ideas. When Friedman said that nothing was free, he meant that everything has a cost. Take the proverbial free lunch that Friedman delighted in pointing out didn't exist. Suppose I invite you to lunch and it's on me—I promise to pay and I keep that promise. Free, right? No, says the economist.
Economist: There's no monetary cost. Today. But there's an expectation that you'll return the favor and treat me to a future lunch.
You (believer in the free lunch): But you don't realize I'm not a nice person. I don't plan on reciprocating and I'm going to keep that promise to myself. Today's lunch is free.
Economist: No. Even if you don't plan to reciprocate, the guilt at being a moocher is a cost.
You: You don't realize just how not-nice I am. I have no conscience. So I do get a free lunch.
Economist: Alas, no. You have to listen to me talk while we're eating.
You: I won't be listening. I'm going to daydream about an upcoming vacation. I'm going to pretend to be pay attention.
Economist: Still not free. The cost of having lunch with me, even when I pay, even when you don't plan on reciprocating and even when I do all the talking that you ignore, is the pleasure you would have received doing something else instead. Whatever you gave up to have lunch with me. Not just the money. Not just the time. But the value or pleasure you would have received from doing something else.
So one of the keys to thinking like an economist is always remembering that everything has a cost. This may be one reason economists have fewer friends than they otherwise would. Sometimes people are very happy holding on to the naïve view that something is free. We like the idea of a bargain. We don't want to hear about the hidden or non-obvious costs. Thinking about foregone opportunities, the choices we didn't make, can lead to regret. Choosing this college means you can't go to that one. Marrying this person means not marrying that one. Choosing this desert (usually) means missing out on that one. Sometimes, people just want to eat their cake and have it, too, without being reminded that they missed out on a spectacular piece of pie.
Many people think that this constant harping on opportunity costs and alternatives and tradeoffs is why economics is called the dismal science. Frequent visitors to the Library of Economics and Liberty know better. See The Secret History of the Dismal Science by David M. Levy and Sandra J. Peart
All true. But if you want to get the most out of life, you have to take account of the opportunity cost, the foregone alternatives. Better to make good choices and learn how to live with them than make bad choices in blissful ignorance that lead to ruin. Here are some applications of how understanding opportunity costs helps you get the most out of life.
The real cost of college
What's the cost of college? The obvious part of the cost of college is tuition. It's not room and board because those would be incurred anyway. But the opportunity cost includes the foregone wages from the jobs you could have had if you hadn't gone to college. This is one of the reasons we go to college when we're young without any experience in the workplace—our wages are relatively low so the foregone earnings from going to college are lower.
The return on your investments
Economists do know something about the stock market. If you tell me you have a great investment track record, I want to know: compared to what. A mutual fund manager who earned 12% last year for his investors seems to have had a banner year. But mutual funds indexed to the S&P 500 earned over 15%. If both funds had a similar level of risk, that mutual fund manager had a negative return of 3%. Similarly, holding your assets in the form of cash means foregoing the opportunity to invest them. The opportunity cost of cash is the return you could earn by investing it.
Home ownership and home improvements
Real estate agents like to tell you that a house is a great investment. Your house is appreciating and you get to live in it. Sometimes both are true statements. But appreciation of the house isn't enough to make it a good investment (or a reason to buy a particularly large house on the argument that if the investment is going to appreciate, it's better to have a bigger stake). Home owners like to savor how much they sold their house for above what they paid for it. When measuring the return, they rarely subtract the direct monetary costs—the repairs, the taxes, and the fees and commissions of lawyers, real estate agents and government agencies. But I've never known the proud Boston or Washington or L.A. house seller who calculates the foregone investment opportunities from tying up the down payment and the mortgage payments over the life of the time in the house.
Similarly, real estate agents (and contractors) like to tell you that re-doing your kitchen is a good idea because you'll get the money back in the form of a higher price when you sell your house. So the kitchen is free! And in the meanwhile, you get to enjoy the pleasures of the kitchen. That logic is fine as long as you get enough pleasure from the kitchen to offset the opportunity cost of tying your money up in cabinetry and granite and giving up the return you could have earned doing something else with the money.
One aspect of home ownership and opportunity cost is particularly tricky. Suppose your house appreciates. You could sell it and move to a smaller house or a house in a different neighborhood. But you decide to stay. The appreciation of your house means it has gotten more costly to live in it. But that increase in cost, being an opportunity cost rather than an out-of-pocket cost does not mean you are worse off. In fact, it is a sign that you are better off—an asset you own has appreciated and your wealth is higher at least as long as the appreciation stays in place. Opportunity cost is different from what we think of colloquially as cost, which usually means a monetary payment. Opportunity cost guides rational decision-making. But an increase in costs doesn't necessarily mean that you are worse off than you were before.
Sunk costs are sunk, historical costs are history
Opportunity cost is a forward-looking concept. If my car breaks down and I fix it, and it breaks down again, the decision to fix it a second time is independent of the first repairs costs. It is irrational to think that I have to fix it because I've put so much money into the car already—if I don't fix it, I'll lose all the money I've already invested. I've already lost the money on the first repair. Now I should only ask whether the second set of repairs are worth it.
A variation on the "sunk cost" argument is the irrelevancy of historical costs. What the seller paid for a house twenty years ago has little effect on the market price today. Complaining that the seller is charging an exorbitant price compared to what the seller paid originally, only insures you will have trouble finding someone to sell you a house that meets your standards of a fair price. On the flip side, explaining to a prospective buyer in a housing market that has collapsed, that your price is high because after all, you paid a lot for it once and it's only fair that you get your money back plus a fair return, is unlikely to be a successful strategy for selling your house. Market prices ignore history.
Replacement costs are more relevant than historical costs. If a friend gives you a Van Gogh as a wedding present and a few years later, a drunken dinner guest plunges a carving knife through it after losing his balance, your guest wouldn't tell you to shrug it off because after all, it was a gift, you didn't pay anything for it.
Self-sufficiency vs. relying on others
Perhaps the most important application of opportunity cost is the decision to do things for yourself vs. hiring someone. Doing it yourself is often cheaper and can be fun. But the cost of doing it yourself is the value of the other things you could have done with your time. Those other things might include working a part-time job or doing consulting, which means you forego money. So doing it yourself can be costly in the monetary sense. But the non-monetary costs can dwarf the monetary costs. Time spent painting your house yourself is time you can't spend reading to your children or being with your spouse or volunteering at the local soup kitchen.
Ultimately, anything close to genuine self-sufficiency is the road to poverty. An avid do-it-yourselfer might change her own oil, bake her own bread and build a bookcase in her basement workshop. But she won't forge her own steel and the fashion her own car. She won't grow her own wheat or mill her own flour. She won't cut down a tree and plane the wood for that bookcase. And even if she did, she'll buy the saw. She won't make it for herself.
Opportunity cost is key to understanding the concept of comparative advantage. See Comparative Advantage, by Lauren F. Landsburg and Treasure Island: The Power of Trade Part I. The Seemingly Simple Story of Comparative Advantage, by Russ Roberts.
By specializing in a very small set of skills, selling those skills in the marketplace and relying on the skills of other specializing individuals we create much of what we call specialization. We specialize because the costs of self-sufficiency are so high.
Of all the constraints we face, the constraint of 24 hours in a day and a finite lifetime are ones we cannot escape. Getting the most out of life means using that precious time wisely. Using that time wisely means using and understanding opportunity cost.