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Chapter 3
CHOICES = COSTS: YOU CAN'T HAVE ONE WITHOUT THE OTHER!
"I'll buy it if it's worth the cost." All economic analysis rests on those two concepts of “worth” and “cost”. In making
decisions about proposed actions, you compare their anticipated cost to the personal worth. If the cost is less than the
personal worth, you take the action. If it's not less, you don't. That's easy to see, so Economic analysis is easy -- if
you understand well the concepts of cost and personal worth. To ensure that you do , this chapter defines, elaborates
and illustrates the concept of cost, with an episode of childish simplicity – but mature perception.
Annie was told by a candy store owner: "You're such a nice child. I want to give you some candy for free. You select
whichever one you want." After jumping with joy and contemplating the variety of candy, she impishly responded,
"Thank you. But, it's not free!" Annie’s smart! She recognized that choosing her favorite, a Snickers, is costly. She
would have to give up her next best-liked candy, M&Ms – her alternate highest-worth good. With that one insight
Annie revealed she could pass a course in Economics. She understood the meaning of cost. It's crucial that you
understand the concept of cost if you intend to pass this course. That will be easier if you are aware that costs can
occur in several forms, and that some things that are not costs are often called costs. This chapter examines some of
the forms of costs. They needn't be memorized. Once their nature has been understood, you’ll be able to readily
recognize what they are.
Definition of Cost of a Chosen Action
Loosely speaking, the cost of an action is the best alternative you otherwise would have chosen. The cost is what you
forego. When Annie chose the Snickers candy, she gave up one of the several other kinds of candy she could have
had instead. The best – the highest valued alternative in her opinion – were the M&Ms. So, for Annie, the cost of the
Snickers, was the M&Ms. When Annie chose the Snickers, she gave up the opportunity to have her best alternative –
some M&Ms. That's why she said the Snickers was not free. The term "opportunity" is sometimes used with “cost” -"opportunity cost" – to emphasize the idea that the cost of an act is the best of the foregone opportunities. The
concept of cost is really that simple.
Definition of Cost (in five easy words): The Highest Valued Forsaken Alternative.
What may be a bit confusing in Annie's case is that she did get something "for free.” The confusion is removed if we
recognize the difference between (a) the right to choose among the specified items and (b) the act of making the
choice among them. Annie gave up no opportunities in accepting the invitation to choose. That was a gift, the right to
make the choice. But, when she acted in choosing the Snickers bar, a cost occurred – foregoing the M&Ms--her most
highly valued forsaken opportunity. Annie could have had M&Ms, peppermint candy, caramel chews, red hots, or Mars
bars. But, her most highly valued option was the Snickers, and her most highly valued alternative opportunity foregone
was the M&Ms. Understanding the concept of cost as well as Annie does can save you millions of dollars. It’s that
important.
Some Confusions
Though the concept of cost is very simple, there are several sources of potential trouble.
(a) Consequences vs. Costs
It's important to distinguish between (a) the cost of a chosen act and (b) the "bad" consequences of that chosen act.
People say that the cost of playing tennis is the resulting sore arm. Or that the cost of studying is eye-strain. On the
contrary, the eye-strain is a consequence, or part of the act, of studying; the sore arm is a consequence, or part of the
act, of playing tennis. Don't confuse the undesirable features of a chosen act with its cost – the best alternative given
up. The cost of "studying and getting a headache" is the "best opportunity" thereby given up, as, for example, playing
video games for the 2 hours that you chose to study. Or, if instead of playing tennis and suffering a sore arm you
would have gone to a movie, the cost of playing tennis is the movie you chose not to see.
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(b) What Precisely Is The Action?
Another source of confusion is a failure to accurately specify the act. Consider the three related activities for an auto.
The three are: (1) purchase of title of the automobile; (2) the continued possession of the title to the car; (3) the use of
the car. Each of these acts has its own cost. Suppose a car with a purchase price of $20,000 could immediately be
resold for $19,000. What is the cost of purchasing title to the car? Is it $1,000 or is it $20,000? The cost is $1,000,
because your wealth is reduced by only $1000 when you purchase the car. ($1,000 = $20,000 minus the immediate
resale value of $19,000). Only $1,000 is forsaken. But, then, immediately there is a cost of continuing to own the car.
And there is a cost of driving the car. The moral here is to be "perfectly clear" when you are referring to some activity.
You can see that what may have seemed like a clear, unambiguous act can be a collection of distinct actions. In a
later chapter we'll examine and illustrate this kind of situation in more detail.
Question: If the cost of acquiring title to the car is $1,000, rather than $20,000, what is the other $19,000?
Answer: You started with $20,000 worth of assets in some form, say, cash. You ended up with $19,000 worth of assets
in another form, the car. So, you incurred a cost of $1,000 (=$20,000-$19,000) and you converted $19,000 worth of
assets from one form (cash) to another (the car).
(c) Full vs. Money Price
You must be careful, also, to avoid thinking of only the easily noticeable forms of cost. Consider a few. More than
money payments are involved in the costs of most acts. When you purchase a compact disk for $10, suppose you
spend an hour of time otherwise available for some other activity, like working at $8 per hour. The full cost of the
purchase is $18, the $10 money payment plus the $8 value of what you could have done with that time. Now suppose,
instead, you had an agent do the shopping, purchasing, and delivery for a total money price of $15 ($10 price of the
CD plus the $5 cost of the agent's services). That would have been cheaper, though the money price was higher – $18
full cost without the agent compared to $15 with the agent. In this case, the difference in “full cost” depends on the
value of how you could have otherwise used your time.
The value of how you can use your time is one reason you don't drive across town to purchase at a lower money price
– but higher full price. The higher value of time for some customers is why convenience stores thrive. Richer people
(who have higher-valued alternative uses for their time) typically pay higher money prices to get faster service. They
don't shop around to save a dollar waiting in lines as long as do people with lower hourly earnings. Wealthy people
pay higher greens fees on golf courses or higher fees for tennis courts that have less waiting time or faster play; they
insist that sellers of service (restaurants, hair stylists, tailors, lawyers, doctors, auto mechanics) provide reservations
and faster service. The rich pay a higher dollar price for the faster service, because the greater value of time saved
reduces the full cost for them. Conclusion: Do not regard the money price as the full price. Concentrate on all the
components of cost.
(d) Expenditures vs. Costs
Another confusion is between expenditures and costs. An expenditure (payment of money) is not a cost if you are
already obligated to make the payment, as when you repay a debt. So be careful not to confuse them. After you buy
an automobile under an installment payment plan, the later expenditures, when made, are not costs. You incurred the
cost at the moment you agreed to the installment plan. At that moment, you gave up your right to the stipulated
amount of future income. When making the installment payments, you are fulfilling an obligation, paying off an earlier
debt. Those expenditures are not costs--and some costs are not expenditures, as we’ll see next.
(e) Implicit Form of Costs
Reversing the situation of the preceding paragraph, costs can occur without expenditures. If I use my garage as a
workshop, the cost is in an implicit form – the loss of the storage space for my car. Because no expenditure is involved,
the cost is considered “implicit.” The implicit cost here is the best alternate use that I gave up. Already owned
resources are not costless to use, because their use for "this" means giving up the opportunity to use them for "that.”
Such implicit forms of cost are also called “opportunity" costs, to emphasize the opportunity to use something you
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already own. As noted earlier, however, all forms of costs, even when you buy something, can equally well be called
"opportunity costs,” because an opportunity to do something else is foregone.
Example of Changes in Implicit Cost
We give now an example of an important form of implicit cost. You’ll surely be misled by reports about a business
firm’s costs, profits and losses, if you forget that the cost of using a resource is its highest-valued alternative use.
Suppose you have just purchased a used car for $15,000 to use in a limousine service business. You contemplate a
100,000 mile service life, with zero final resale value. The depreciation due to use of the auto, would be $.15 a mile (=
$15,000/100,000 miles). Suppose, happily, the day after you bought the car, it is discovered to have once been owned
by Elvis Presley and could, therefore, be resold for $100,000! You’ve just gained $85,000 in wealth. But at the same
time, the depreciation, of the car has increased from $.15 a mile to $1 a mile. (=$100,000/100,000 miles). You have,
fortunately, become wealthier. But, you now lose more of that greater wealth with each unit of use. It’s the car’s cost
per mile – depreciation – that is now higher. Depreciation always must be based on the pro-rata share of its current
value – never its initial purchase price.
Often, adversity and misfortune make us understand the world more clearly. Suppose you buy a used car for $15,000
for a taxi service, and the next day you discover some defects in it, which reduce the value of the car to $5,000.
You’ve suffered a wealth loss of $10,000. However, the depreciation per mile of use of the car falls to 5 cent per mile,
(=$5,000/100,000 miles) assuming the car will still render 100,000 miles of service. Again, the point is that the
depreciation of an asset is the decrease in its current value, not in the initial value at the time of purchase. Only the
current value is pertinent for output decisions. This implies that whether or not earnings on your limousine business will
be sufficient for a profit on the initial investment cost is irrelevant for current use of the car. Please keep this example of
changes in values and costs in mind. You’ll have many occasions for using it in your later years – and many
opportunities to suffer a wealth loss if you forget to use it!
(f) "Sunk Cost" is Not a Cost
The concept, "sunk costs", is especially important in many of your decisions. Suppose you are writing a term paper for
a class and have already spent 20 hours on it. Someone says you could write a paper on a different topic and get a
better grade. Would your decision depend upon how much time and effort you have already spent on the present
topic? We hope not! That time spent is sunk, gone, and unaffected by any future actions. A sunk cost was the cost of a
past act. It is not a cost of any present or future action. It may provoke tears, sadness and regret. Costs of past acts
are bygones, sunk and irrelevant for present acts. However, at the earlier time of the initial action, the contemplated
act's foreseeable (but not yet incurred) sunk cost is of prime relevance in deciding whether to undertake the act. (This
will be elaborated upon in a later chapter on investments.)
(g) Time Used vs. Time of Use
Time passes no matter what you do. It can't be saved and accumulated; there is no choice about delaying or speeding
up time. Therefore, in the precise meaning of cost, the time required to do something cannot itself be a cost. Instead,
the cost is the alternative act that otherwise would have been accomplished within that amount of time – possibly later
and not just at the present moment.
Costs Borne By Other People: Externalities
Not always will you bear the costs of your action. You may impose some losses on other people. That could happen if
you stole some of the resources you were going to use. Or your action might damage something owned by someone
else. At a most trivial level, if I buy and eat a hamburger with onions during a close conversation with you, that's legal,
even though I have polluted the air you breathe. Eating the onion-laden hamburger in your presence imposes a loss on
you – the opportunity to have cleaner, sweeter smelling air. Similarly, if I turn up my sound system and annoy
neighbors, or throw litter on their land, or drive my noisy motorcycle near their land, I am abusing – reducing – the
benefits they receive from their property rights in land. But often the “actor” abuses resources that aren't owned by
anyone. If a steel mill discharges polluted water, or if a refinery emits pollutants and reduces the quality of air, these
acts change the physical characteristics of resources over which no one seems to have perfectly enforceable and
transferable property rights. Actions that are legal but which impose costs or losses on other people are called
"externalities." Whether such actions are legal usually depends on the cost of assigning and protecting property rights
over the abused resources.
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Trivial harms to other people's property are permitted if the harm is a "minor" side effect of some productive action, or if
its prohibition is too expensive relative to the benefits of initiating action. Many external effects typically are tolerated
because the costs of prevention by laws would exceed the benefits of prevention. For example, smoke from a
neighbor’s bonfire of leaves in the fall season is legally "'dumped" on neighboring property. The harm is typically trivial
relative to the costs of enforcing a ban and relative to the convenience of disposing of leaves by burning. The same is
true for typical traffic noises. As a matter of terminology, the permissible – though harmful – physical effects are called
"externalities." But, if declared illegal, they are called "crimes" or "theft" or "misdemeanors" punishable by government
power. The key distinction between tolerated "externalities" and governmentally restrained effects, called "theft" and
"damage" hinges on the severity of the effect, the benefits to the initiator and the costs of prevention.
"Compensated Externalities" Are Not Considered To Be "Externalities"
If when I burn leaves and you owned well defined and enforceable property rights to air over your land, I would have to
compensate you for the right to dump smoke on your property. Then I would have to take those costs into account
when deciding whether to burn leaves or haul them to a dump. The costs would be "internalized" (borne by me). My
actions that created these “external" costs on you would, in that fanciful world, be only those which I would bear by fully
compensating you. But, since complete private property rights are not perfectly enforceable over all resources, people
aren't forced to take account of and bear all the costs. As another strong example, an employee works, strains, and
suffers. That would be an external effect imposed on the employee by the employer – if the employer hadn't agreed to
pay enough to the employee for the right to have the employee do that work.
Environmental Pollution
All the preceding definitions of externalities may seem to be merely a piling on of extra labels and names. But in fact it
does more; it makes distinctions in conceptions and circumstances that clarify a problem. For example, much of the
"pollution" in the analysis of "environmental pollution" can be avoided if these distinctions and features are recognized
as we'll illustrate later in resolving what appear to be opposing, irreconcilable uses of a resource. You can now see that
what is called "pollution" is simply using an unowned resource without compensating its owners. Why are they not
compensated? Because there are no owners. If owners could demand compensation for permission to use the
resources, as it is with ordinary purchases, the consequences would be "internalized" on the responsible person and
pollution would be controlled.
As an illustration that complete, exhaustive, private property rights are difficult to specify and enforce, consider a parcel
of land. To whom does the right to a view across the parcel of land belong? That land's owner or the owners of
neighboring land? It would make no difference so long as someone did own it and that ownership were salable. Then
that right could be bought, just as land is bought or as one's labor is bought from an employee by an employer. The
effects and costs and benefits would be "internalized" on the actor.
Pecuniary Externalities
These examples of externalities were examples of "physical" externalities – on the physical attributes or uses of a
resource. There are also "pecuniary" external effects, without any physical impact. "Pecuniary" effects are changes in
the market values of resources. An example of the source of a pure pecuniary externality is in your hands -- this
textbook. When published, it lowered the market value of competing texts. That effect on their market values is a
"pecuniary" effect. We didn't have to compensate other text publishers for the loss in the market value of their texts.
We didn't affect any of the physical aspects or capabilities of their textbooks. No one has rights to particular market
values of resources. The market value depends on offers of other people. No one has the right to make other people
continue to buy something and to do so at a specified price. That kind of "right" is certainly no part of private property
rights. Only governments have that right -- in the power of taxation. [Note: Reread this paragraph carefully because it
is key to understanding the recent Supreme Court decision on “Obamacare.” The Patient Protection and Affordable
Care Act (the formal name for “Obamacare”) was generally declared a constitutional act because the court found that
the payments people will be mandated to make to purchase health insurance are a tax.]
Inducing Beneficial Externalities
Some of your actions improve the resources or environment of other people, increasing the benefits they derive from
their property, though you weren’t paid to do that. Examples are better hygiene, prettier gardens, politeness, etc. How
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are we persuaded to do that when we are not paid to do so, or when no reward can be forced from the beneficiaries?
Social pressures, social approbation, ethics – such as "Keep up the neighborhood" or "Neighborhood Watch" – are
sometimes influential. Also, government rules and regulations are applied, as in compulsory vaccinations.
Costs and Effects of Actions
The distinctions among costs, losses, rights and externalities are not hair-splitting trivial distinctions. They are trivially
easy, but they are profoundly important in analyzing economic events, and more to the point, in making your own
decisions.
Definition of Cost: The cost of a chosen act is the best of the alternative actions foregone.
Interpretation of a "Choice": The chosen act is the one most preferred of all options.
Full Cost: Money plus other resource costs
Implicit Cost: Best alternative use value of already possessed resources.
External Cost: Reduction of options of uses of resources owned by other people and for which no
compensation is made to the other people
Sunk Cost: Past cost of a past action; not a cost of any current or future choice.
Comment:
Given that I have rights to myself and my labor. I cannot be forced to work except by offering me sufficient
compensation -- exceeding the worth of what I could have done instead. If I had been forced to work at less
compensation, I would be suffering an "externality" of the actions by another person. But when compensated, the
"externality" has been "''internalized" onto the person (say, an employer). We already have terms for that, such as
"purchase", "sale", and "wages.” On the other hand, we could use the expression "'uncompensated externality" to
mean "taking without compensation" or “theft.” Later we'll examine some important examples of existing externalities
– effects on other people or unowned resources for which no compensation is made.