The opportunity cost, when performing an action, is the value attributable to the best alternative foregone. In other words, it is the opportunities an actor has given up for something else.
As an example, suppose Amy, an economic actor, wishes to purchase a chocolate bar. Her preferences are ordered as follows:
- Crunchie Bar
- Mars Bar
Should Amy choose to purchase a Crunchie bar, she gives up her second highest preference, the Mars Bar. Assuming these bars are priced equally, the opportunity cost of her decision to purchase the Crunchie Bar is the Mars Bar.
Opportunity cost and trade
See also: Comparative advantage
For example, Amy can produce either one hundred oranges or ten tires in a day while Chen can produce ten oranges or two tires in a day. It doesn't look like they have anything to gain by trading: Amy is much more productive than Chen.
But compare their opportunity costs. To produce one hundred oranges, Amy gives up the opportunity to produce ten tires. Her opportunity cost of an orange is one tenth of a tire, and her opportunity cost of a tire is ten oranges. Chen's opportunity cost of an orange is one fifth of a tire, and her opportunity cost of a tire is five oranges.
In terms of tires, it is cheaper for Amy to produce oranges because she only gives up one tenth of a tire to produce an orange while Chen has to give up one fifth of a tire. In terms of oranges, it is cheaper for Chen to produce tires because he only gives up five oranges to produce a tire while Amy gives up ten oranges to produce a tire.
They can both have more oranges and more tires if they specialize and trade. Chen can offer Amy one tire in exchange for seven oranges. Chen would be better off because he would get seven oranges in exchange for one tire, while he would only get five oranges for one tire if he produced them himself. But this is attractive for Amy too, because she can get a tire for only seven oranges, which is fewer than the ten oranges she would have to give up if she produced tires herself. At any "orange price" of tires between five and ten, Amy and Chen are both better off.
The same logic is valid for countries - countries are also better off if they can specialize and trade.
Subjectivity of costs
Costs are by nature subjective and not objectively measurable by an outside observer. An essential feature of Austrian economic theory, unlike the neoclassical theory, is that cost is directly related to the act of choice. A summary of the implications follows:
- Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
- Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
- Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
- Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
- Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
- Finally, cost can be dated at the moment of decision or choice.
Therefore, there can never be objectively measurable external benefits. Costs (or benefits) are subjective and are inseparably tied to the act of choice. That is, an individual not involved in the economic decision or choice can never objectively measure another individual's costs (or benefits). Thus no statement about either the size or the very existence of external benefits can ever be falsified, and cannot be an argument for government intervention.
Consider the classic example of the beekeeper adjacent to an apple orchard. The benefits accruing to the apple orchard from the beekeeper's production (pollination) are not considered by the beekeeper in determining his profit maximizing output level. Therefore, from the point of view of the apple grower the beekeeper is "underproducing." Many economists would agree that, since the costs of reaching an agreement are relatively small, this two-person case is not a problem for the government. The apple grower can simply bribe the beekeeper an amount up to the size of his perceived external benefits and thus induce the beekeeper to increase production.
As the number of beekeepers and apple growers increases, the costs of reaching an agreement on the size of the payment from the apple growers to the beekeepers increase. If the transaction costs remain less than the possible gains from trading, an agreement will be reached. If, on the other hand, the transaction costs exceed the benefits from any trade, an agreement will not be reached. Under these circumstances many economists argue that the market has "failed" and that government intervention is therefore necessary. However, to argue for the government subsidization of the beekeepers is to ignore the fact that transaction costs are real costs which must be considered when making a trade. In the real world, when collective action does not take place, all that one can conclude is that the benefits of such action are smaller than the costs involved. In no way does this imply that the market has failed.
The existence of transaction costs explains why certain trades do not take place in the market. Asserting that the trade should have taken place is equivalent to stating that transaction costs are not real costs and somehow should not have been considered by the parties involved.
As an example, all of us have wished many times in our lives that we could be instantaneously transported to our destination, be it for work or recreation. Many times the existence of transportation costs (time and money) has led to a decision to stay at home. However, the existence of transportation costs explains why people make certain decisions, and by no means can be used as an argument for government intervention on the grounds of high transportation costs. That is, it would be incorrect to argue that resource allocation is not optimal because of the existence of these transportation costs. On the contrary, any subsidy payments would alter the pattern of resource allocation, making one course of action seem cheaper than it formerly did.
- Ludwig von Mises. "4. Action as an Exchange", Human Action, online edition, Chapter IV. A first analysis of the category of Action, Mises Institute. Referenced 2009-05-14}.
- Art Carden. "Tire Trade Tirade", Mises Daily, posted on Monday, October 12, 2009. Referenced 2009-10-13.
- Barry P. Brownstein. "Pareto Optimality, External Benefits and Public Goods: A Subjectivist Approach" (pdf), Journal of Libertarian Studies, Vol. IV. No.1 (Winter 1980). Referenced 2010-05-27.
- Cost at Wikipedia
- Opportunity Cost by David R. Henderson at The Concise Encyclopedia of Economics
- Richard Cantillon and the Discovery of Opportunity Cost (pdf) Mark Thornton
- Subjective Cost Revisited (pdf), by William Barnett II
- Austrian Economics and the transaction cost approach to the firm by Nicolai J. Foss and Peter G. Klein
- Cost and Choice: An Inquiry in Economic Theory, Preface, by Buchanan, James M., 1969
- What's Cost Got to Do with It? by Joseph T. Salerno, December 2010