"People often do not seem to take opportunity cost into account in the way more traditional economics would predict. It appears that we value gains differently from losses."
There's this concert. Green Way is coming to town. To hear those great songs from American Dolt performed live you are going to stand in line, camping out for tickets. You get to the box office about midnight, but don't sleep much because it's noisy. Finally, sleep does come. It only seems like a few minutes later when the clank of the ticket window opening wakes you at 8:00 am. In the sunlight, you notice that there are way more people in line than you thought. Thousands, in fact. You may not get tickets, even after camping out.
Three hours later, the line has snaked along nearly to the window. You can see the guy behind the glass, taking money and handing back tickets. But you are getting more and more anxious. And with good reason: the ticket window clanks loudly again, this time on its way down. Sold out? SOLD OUT! Oh, no. Your main squeeze was counting on those tickets. She just loves Green Way.
Now you walk alone towards home, head down, disconsolate. But then you hear a hubbub across the street. It seems that some people who were first in line were not Green Way fans at all! They bought up tickets just to resell them. And reselling them they are, busily and noisily. Excellent—you may still get lucky.
You scurry across the street, and join the crowd surrounding the (to put it nicely) "resellers." When you hear what they want for a ticket, though, you are incredulous: "Three hundred bucks, dude. Cash only."
What's even harder to believe is the fact that people are paying $300 per ticket. You have to stop and review the pros and cons. It happens that in your state, "scalping" entertainment tickets is legal. Further, you yourself have no moral compunction about scalping. You have enough cash saved up to pay $600 for two tickets. And all tickets are general admission, so there are no reserved seats.
Definition: Opportunity Cost (David R. Henderson, Concise Encyclopedia of Economics):
When economists refer to the "opportunity cost" of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can't spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book.
But you start thinking about opportunity cost, the big OC. You recall from economics class that the OC is about foregone alternatives. In other words, the cost of doing one thing is all the other things you don't get to do as a result.
And $600 is a big cost. You don't so much mind the money, but if you were going to spend $600 you could buy every Green Way CD ever made, plus a first-class MP3 player to play them on. And you'd have enough left over to take your boy/girlfriend to dance clubs and dance to Green Way songs every Friday night for a month. (It's a safe bet the clubs will play Green Way, since that is all they play right now, especially that ecological anthem, "Nader of Suburbia").
The point is that money itself is not the whole cost of any activity. The true cost is what you give up: spending the money on X means you don't have that money to spend on Y. So the real cost of X is… Y. Some economists have claimed that money is simply a "veil," masking the fact that money prices are measures of relative scarcities of commodities.
If you go to the concert, you would be giving up 10 CD's, at $20 each, an X-pod MP3 player for $250, and $150 worth of cocktails down at the dance club. All for just one 2 hour concert. You think about it some more, and then shake your head. It's not worth it.
Having decided, you set off toward home, your chin drooping toward your chest. After going twenty blocks or so, you notice a scuffed up envelope, out in the road a little way from the sidewalk. The outside of the envelope is blank.
You pick it up with a strange feeling, a quickening heart. You tear the envelope open…and in it are two Green Way concert tickets! Oh, baby!
But then… guilt. These tickets aren't really yours. On the other hand, if the envelope blew out a car window, the people who lost them could be miles away by now. They may not even know they lost the tickets.
Still, you wait for nearly an hour. Every time a car goes by, your shallow heart's the only thing that's beating. But no cars slow down, and nobody comes by on foot looking for an envelope. You can hardly just hold up the tickets and say, "Anyone lose these?" And since the concert is festival seating there is no way to identify the true owner anyway. The tickets are yours, fair and square.
So, you call your consort on the cell phone, and you tell him/her the great news.
End of Story.
Now, a question: What's the news? Do you go to the concert, and if so, why? Assume you are "rational," in the conventional economic sense.
I used this fable (sort of—it was Bruce Springsteen then) as a test question in my intermediate Microeconomics class at Dartmouth College in spring term, 1986. I assumed that the question would be easy. The kids at Dartmouth are smart, and they clearly knew the definition of opportunity cost. In fact, they had the OC down cold.
But more than half of them missed the question; some of them missed it completely. Let's consider some things you might tell your boy/girlfriend on the phone, as well as the grades I would assign to each answer.
You fail; back to school. The tickets are not free. Remember, you don't mind scalping, scalping is legal in your state, and you saw scalped tickets actually transacting at a price of $300 each. And you established, after careful thought, that the concert is not worth the $300 opportunity cost for each ticket. The opportunity cost of attending the concert is still $300, even if you found the tickets on the ground.
Too simplistic on the other side of the question. Remember, you do have to walk twenty blocks back to the area where tickets are being sold, and then hawk the tickets. So, if you are going to sell the tickets, you have to say why. It is actually not obvious that you sell them, any more than it is obvious that you keep them.
Now we could debate my grading scale. It might be that a student would mention income effects, and transactions costs, and still decide not to go, and that would also be an A+ answer. But the point is that "I have free tickets! We're going to the concert!" is always wrong, completely wrong, brutally misguided.
Yet more than half of my students put "They are free! We are going!" as their answer. What a bad economics teacher I was.
Opportunity Cost is Not the Way People Think
From Bureaucracy, by Ludwig von Mises:
Whether one likes it or not, it is a fact that the main issues of present-day politics are purely economic and cannot be understood without a grasp of economic theory. Only a man conversant with the main problems of economics is in a position to form an independent opinion on the problems involved. All the others are merely repeating what they have picked up by the way. They are an easy prey to demagogic swindlers and idiotic quacks.
Their gullibility is the most serious menace to the preservation of democracy and to Western civilization. The first duty of a citizen of a democratic community is to educate himself and to acquire the knowledge needed for dealing with civic affairs. The franchise is not a privilege but a duty and a moral responsibility. The voter is virtually an officeholder; his office is the supreme one and implies the highest obligation. A citizen fully absorbed by his scientific work in other fields or by his calling as an artist may plead extenuating circumstances when failing in this task of self-instruction. Perhaps such men are right in pretending that they have more important tasks to fulfill. But all the other intelligent men are not only frivolous but mischievous in neglecting to educate and instruct themselves for the best performance of their duties as sovereign voters.
See also Bryan Caplan's two-part essay, "Mises and Bastiat on How Democracy Goes Wrong", contrasting Mises's view with Bastiat's on the question of democracy and economic understanding: Part I, Part II.
I whined about this outcome to my professor colleagues. The economists I talked to weren't really surprised. "People don't understand opportunity cost. For that matter, they don't understand lots of other apparently simple economics concepts. That's why we should study economics more." I'm not sure this is right. It reminds me of Bill Niskanen's (1971) observation about Ludwig von Mises. Niskanen argued that many people, including von Mises, were too optimistic, resting their conclusions on "the hope, almost pathetic in retrospect, that a broader education in economics will reduce the popular support for large government and the consequent pervasive bureaucracy."
Niskanen was not persuaded that economics is quite so self-evident, at least not to the large mass of the public.
Instead, it would appear that the answer is simpler: people just don't think this way, even if you try to teach them economics as a way of thinking. My evidence for the claim is that most people don't find my explanation persuasive. And my colleagues from other disciplines consider the apparently obvious economics argument to be empirically false from the outset, at least as a description of human behavior. "Of course people go to the concert; if you found tickets for free, and didn't take your partner to the concert, that relationship would be over, for sure! Don't be so analytical!"
Anthony de Jasay wrote an interesting article, here at Econlib, describing the importance of analysis. Jasay repeated Frédéric Bastiat's admonition to focus on what comes down to opportunity cost: "When a man is impressed by the effect that is seen and has not yet learned to discern the effects that are not seen, he indulges in deplorable habits, not only through natural inclination, but deliberately." (Bastiat, par. 1.4.)
To be fair, there is some support in the psychology and behavioral economics literature that people often do not seem to take opportunity cost into account in the way more traditional economics would predict. It appears that we value gains differently from losses; once we have the tickets, we would be giving them up, which is different from deciding whether to spend money to acquire the tickets. The fact that the value ($600, in this case) happens to be the same for the gain or the loss is largely irrelevant. This perspective is related to the "heuristics and biases project" in cognitive psychology (as developed by Kahnemann, Tversky, and others). This particular bias, known as the "endowment effect," rests on the empirical claim that people value things they already have more than they value something they haven't yet purchased or acquired, even if it is the same thing at the same price.
From Anthony de Jasay, "The Seen and the Unseen: The Costly Mistake of Ignoring Opportunity Cost".
Perhaps the most important area where public policy tends to overlook opportunity cost is in the defence of "what is seen". Bastiat takes issue with the poet and revolutionary deputy Lamartine over subsidies to the arts and the theatre. Maintaining these activities by state aid serves a worthy aim, including employment for artists, actors and artisans, but Lamartine sees only what is thus preserved. He does not see the opportunity cost, namely that the resources devoted to the arts would have served other aims that corresponded to what people actually chose rather than to what the state induced them to choose by subsidizing a particular branch of activity. Bastiat does not deal with the idea of "merit goods" that ought to be produced whether the public wants them or not. But he stresses that promoting the fine arts can only be done at the cost of cutting back other things—a loss we do not see. It is, he notes, impossible to promote everything at the expense of everything else. This echoes his famous definition of the state, "the great fictitious entity by which everyone seeks to live at the expense of everyone else" ([Bastiat] online, pars. 1.69-1.73.).
But I'm not convinced. People may just get it wrong. (To be fair, Kahnemann and Tversky also think the choice is "wrong," from a rational choice perspective, so I am not disagreeing with them in any important way). Expecting them to get it right rests on the hope, "almost pathetic in retrospect," that citizens are educated in basic economics.
I put my little OC question to people on airplanes, or ask it of people I meet at conferences. And they are decidedly split, even after I explain the "correct" answer. More or less the same problem comes up all the time regarding basketball games at Duke University, where I teach. The face value of a basketball ticket to Cameron Indoor Stadium is $40. But for most games one could get a lot more than that. For some games, in fact, like Duke vs. UNC, the value of a scalped ticket is well over $1,000. In 2006, the value was more like $2,500. So, when faculty ask me (as department chair) for a raise at the end of the year, I will remind them that they don't need more money, because they are already rich.
"What do you mean?" they ask.
I reply, "Well, you can afford to spend $2,500 to go to a basketball game. You must be wealthy."
They show me the ticket. "$40! It's a $40 ticket!"
My response? "Tell you what. I have $50. Will you sell me the ticket for that price? After all, you claim it's a $40 ticket."
So far, I haven't been able to buy any tickets that way, even from people who tell me that opportunity cost is a stupid concept.
Bastiat, Frederic. 1848. "What is Seen and Not Seen."
Buchanan, James. 2001. Cost and Choice: The Collected Works of James M. Buchanan. Indianapolis: Liberty Fund.
Caplan, Bryan. "Mises and Bastiat on How Democracy Goes Wrong, Part I"
De Jasay, Anthony. 2002. "The Seen and the Unseen: The Costly Mistake of Ignoring Opportunity Cost."
Mises, Ludwig von. 1944/1969. Bureaucracy.
Niskanen, William. 1971. Bureaucracy and Representative Government. Chicago: Aldine-Atherton.
Tversky, A. and D. Kahneman. 1992. Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty 5: 297-323.