Opportunity Cost Matters
My friend Yusuf and I recently started a Substack called Longterm Liberalism, which aims to bring together insights from classical liberalism and Effective Altruism. Yusuf has two posts up that introduce the blog. One covers the motivation for starting the blog, while the other discusses our principles. He also recently published a post that discusses how Effective Altruists evaluate which problems to work on.
In this post, I want to discuss one big reason that I think EconLog readers should appreciate both Effective Altruism and classical liberalism. Both philosophies appreciate the reality and importance of opportunity cost.
We live in a world where resources, including time, are scarce. As a result, whenever you make a choice, you necessarily give something up. Time you spend reading this blog post is time that you’re not spending on some other task. The money I spent on coffee today is now money that I cannot use to buy concert tickets. The workers in the coffee shop spent time making me coffee, and they cannot use that time for other purposes. Every day, we make choices, and every one of those choices has a cost. Choose wisely.
Classical liberalism is a philosophy of liberty. The liberal favors a presumption of liberty and supports a broad scope for individuals to make choices about their lives, as well as to make voluntary agreements and exchanges with others.
What does this have to do with opportunity cost? First, we should understand that opportunity costs are subjective. James M. Buchanan emphasizes this subjective nature of costs in his excellent book Cost and Choice. Since costs are subjective, an external observer cannot directly discern how much another individual values one option or another. Individuals are therefore likely to better understand what they are giving up when they make a choice for themselves than an external authority will when choosing to impose a choice upon another.
But a question remains: when it comes to any scarce resource, who gets to decide how it will be used? Liberals typically resolve this question using property rights. Property rights are an institution, a rule. When individuals hold exchangeable property rights, then they can choose whether to keep or trade away the resources that they have a right to. If they value their own use of these resources more than what others offer them, then they may keep these resources for themselves. If, on the other hand, someone offers them something that they value more than their next best use of a resource, they will likely make an exchange. In this way, mutually beneficial exchanges occur and goods and services flow to more highly valued uses.
Exchanges give rise to exchange ratios, which we call prices. Prices convey knowledge about the relative scarcities of different resources. When the price rises, whether due to a reduction in supply or an increase in demand, more people have an incentive to enter the market as sellers. And prospective buyers have an incentive to economize on their use of the higher priced resource, as they must give up more to acquire it.
Sellers invest in production plans. The scarce resources invested in these production plans are necessarily taken away from alternative uses. Because capital is multispecific, each capital good could be used for some alternative project. Moreover, because capital is heterogeneous, it cannot be instantaneously reallocated to any other use if a production plan fails. Therefore, an entrepreneur risks wasting resources whenever they initiate a production plan. They do not necessarily know what consumers will value in the future, and their expectations about the future could be wrong. However, if they sell their products in a relatively free market, profit and loss feedback will tell them whether consumers value their products more than the opportunity cost of the inputs. If they make profits, that’s a signal to continue what they are doing. If they incur losses, that suggests they should revise their plans, as their products or services may not be worth the cost.
Liberalism provides an institutional environment characterized by private property rights, which enables the emergence of prices which act as guides and profit & loss which provide feedback. Together, the Three P’s of property, prices, and profit & loss enable individuals to coordinate their plans and take into account the opportunity cost of their use of scarce resources.
Note, however, that most of this involves individuals seeking to satisfy their own subjective preferences. What about when people wish to act altruistically, to help improve the lives of others by their own lights? Effective Altruism is a movement that applies opportunity cost reasoning to the realm of individual altruistic actions. As Yusuf explains:
Political advocacy, charity, and similar non-market actions lack the tight feedback that markets provide. Altruists cannot look into the minds of others and perceive what their subjective preferences are. Effective Altruist methods will not provide a true substitute for property, prices, or profit & loss feedback. However, thinking carefully about opportunity cost and the comparative effectiveness of different ways to change the world can help us use our resources and time more effectively.