Opportunity Cost: the Great Deception

Opportunity cost is singled out for more extensive treatment here because of its far-reaching human and ecological significance, and because it appears to have an intoxicating effect on thinkers, both inside and outside the economics profession.

Among specialists in the field the ideological origins of opportunity cost are completely ignored and the concept is considered utterly inviolable.

The truth about opportunity cost is evident from its history: it is not cost.

It is actually a forgone consumption benefit arising from allocation, not a loss incurred in production. It is what we could have gained, not what we did in fact lose.

A forgone benefit and an actual loss are both sacrifices, but in entirely different senses that must be kept carefully separate. Since opportunity cost became the predominant cost concept in the early 20th century, most economists have bypassed "true cost" — the damage to people and nature in production — and have focused their attention on a related but different subject — allocation.

Despite its lavish press, opportunity cost is a cheap bit of conceptual legerdemain that has been astonishingly successful in diverting attention away from the injuries, deaths, and ecological destruction that accompany many production activities.

The success of the opportunity cost concept cries out for an explanation.

The concept is usually introduced to economics students as follows: Assume you have a free hour in your busy day at school, and you're deciding how to spend it. Your two best options are to study in the library and to attend a documentary film in the theater.

If you choose to study, you forgo the film. Watching the film is therefore the opportunity cost of studying.

Conversely, if you choose to attend the film, you forgo the study option. Studying is therefore the opportunity cost of attending the film.

Another version of this lesson is to focus on money rather than time. You have ten dollars to spend. Your best options are… and so forth.

Most economics students nod their heads vigorously at stories like these because they make perfect sense. Students have understood for years that choices must be made with respect to time and money, and that making such choices entails the sacrifice of alternative possibilities.

Now they have been informed that their intuitive understanding is formally recognized, has an impressive technical name, and is a linchpin in the subject they’re studying. For those who continue in economics, this revelatory experience is often the first step in a lifelong commitment to opportunity cost as the field's most fundamental and unchallengeable tenet.

Note what such stories achieve.

First, they equate the world of personal experience with the economic world of allocation and production, although there is little similarity between the two.

Second, they apply the word "cost" to a forgone alternative — a crucial but highly misleading association.

And third, they establish the idea that all resources are essentially the same as time and money — that is, they are capable only of being spent.

These subtle falsehoods, along with the true nature of cost, can be explained more fully with reference the following figure.

Opportunity cost and real cost
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Only opportunity cost applies to “resources” such as time and money, which can be spent but not degraded. People and nature, when treated as economic resources, can be both spent and degraded in production, so real cost also applies.

At left are four types of "resources" used in production, divided into two categories. In the first category are time and money, which are non-material in nature and therefore not subject to wear and tear in production. They can be spent, but not damaged or degraded, and can thus be called non-degradable resources.1

In the second category are people and nature. Even if we leave ethical issues aside, these are fundamentally different from time and money in that they are material, and thus subject to wear and tear in production. Like non-degradable resources they can be "spent", but they can also be damaged or destroyed. They can thus be called degradable resources.

The distinction between these two types of resources is critical to the protection of humankind and the environment, but it is one that standard economics categorically refuses to make. This refusal is at the heart of the massive deception known as opportunity cost.

When a non-degradable resource is allocated to alternative A rather than B, the only sacrifice incurred is the benefit associated with the consumption of alternative output B. The diagram thus shows that they entail only opportunity cost.

On the other hand, when a degradable resource is allocated to alternative A rather than B, two distinct sacrifices are made. The first is the benefit associated with B, as before. In addition, however, we must count the concrete results of the production process: the damage to people, such as injuries, diseases, and deaths, and the degradation of nature, such as habitat destruction and pollution.

In the diagram, these negative effects are indicated by the downward-pointing arrow. As the diagram indicates, these two cases entail both opportunity cost and "real cost".

To be clear: ENL does not reject opportunity cost. However, the framework notes the concept’s limitations and refuses to apply it beyond these boundaries. ENL recognizes that allocation is a critical economic task. It therefore accepts opportunity cost as a valid concept with respect to allocation and incorporates it as such into the theory — albeit under a name that expunges the deceptive word "cost".

But in addition to this, ENL recognizes "real cost" as the damage to a degradable input. These two sacrifices are discussed further throughout this section.

What is particularly bizarre is that, although opportunity cost is at the core of their discipline, standard economists appear to have spent very little time thinking about the concept. According to Cornell economist Robert Frank:

Virtually all economists consider opportunity cost a central concept. Yet a recent study by Paul J. Ferraro and Laura O. Taylor of Georgia State University suggests that most professional economists may not really understand it.2

In the study cited, 200 economists were asked to specify the opportunity cost involved in choosing between a free Eric Clapton concert and a $40 Bob Dylan concert. The correct answer was chosen by 22% of these scholars — worse than would be expected from a random pick.

A final word on this topic: Those wishing to cling to opportunity cost as the sole economic sacrifice, and thus as a comprehensive conception of cost, may propose that we extend its meaning so that it applies to the damage discussed above. For example, we could speak about allocating worker injuries to this project or that, thereby making human damage amenable to opportunity cost calculations.

This, however, is just another way of conflating allocation and production. Allocation refers to the assignment of resources to production alternatives, not to the assignment of the damage those resources may incur in the chosen production activity.

There is no escaping the fact that two discrete sacrifices exist on the allocation-production axis, and that two separate concepts are required to address them.

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