I want to thank Adam Martin for writing not one, but two thoughtful responses to my essay “Reevaluating the Influence of James Buchanan on Libertarian Thought.” I will respond soon to his post about social welfare functions and debt. For now, I would like to take this opportunity to clarify one link in my essay and then elaborate a bit further on how I think Austrian economists may have been led astray in their understanding of opportunity cost.
First, Martin criticizes me for citing Murray Rothbard whom he claims is not a follower of James Buchanan. I’ll defer to Martin on this matter. The link was included because Rothbard’s description of the cost concept succinctly captures a view that is fashionable among Austrian economists today. That view says that cost is a fleeting, psychological phenomenon that cannot be measured.
Having spent more than a decade working at George Mason University’s Mercatus Center and having earned my doctorate at GMU, I have had many interactions with individuals in the Austrian economics community who hold this perspective of cost or some version of it. Moreover, I find they often point to James Buchanan as a source of inspiration on this topic.
Certainly, there were better citations I could have chosen. As I stated in the original piece, I believe Buchanan’s actual position on this issue was somewhat nuanced (which is also a theme of Martin’s response to me). It is true, for example, that Buchanan would certainly have acknowledged that our decisions can impact the real economy. But no one would deny this.
Buchanan himself defined cost at times in a manner almost identical to the selected quote from Rothbard. Despite his many caveats, Buchanan has written quite clearly that cost is only born by the decisionmaker, is psychological, cannot be measured, and is instantaneous. At a minimum, Buchanan provides legitimacy to a perspective of cost that I see as little more than an economic fallacy.
It is simply untrue that cost is a fleeting, psychological phenomenon. The act of choosing is fleeting and psychological, but that is not cost. That is choice, a completely different concept. Is it so far-fetched to think that the Nobel laureate author of a book titled, Cost and Choice, who espouses a version of this subjectivist argument, might have significantly contributed to Austrian economists conflating cost and choice?
I don’t doubt that other individuals, including Rothbard and perhaps Ludwig Lachmann and others, helped lead Austrian economists down this intellectual cul-de-sac. But they weren’t Nobel Prize winners and they didn’t have the mainstream legitimacy that Buchanan had.
I suspect one of the reasons Austrians followed this unfortunate dead end path is that they are misled by the definition of opportunity cost, so I’d like the spend some of this post exploring this idea, since I think it might provide clarity.
If you open up a textbook, it will often state that opportunity cost is “the value of next best alternative use” of something. But this definition is arguably incorrect. At best, it is misleading, because it constitutes a special case.
Opportunity cost is the difference between what would happen as a result of taking some action and what would occur otherwise. If under scenario A, a factory produces 100 widgets, and under scenario B it produces 95 widgets, the opportunity cost of an action that moves the factory from scenario A to scenario B is 5 widgets. The cost is not 1,000 widgets that might have been produced in some hypothetical scenario C.
Opportunity cost is an objective fact about the world. It involves comparing two moving pictures. It is hard to get our fingers around, because to grasp it we have to understand a counterfactual and our relation to it. But opportunity cost is not subjective. It is both real and quantifiable.
Austrian economists may be thinking of cost as the very best conceivable use of resources, which might be a matter of opinion that differs from person to person. But this is not a very useful definition because the idealized situation it describes doesn’t conform with the state of affairs that would in reality be foregone as a consequence of making some choice.
When I decide what to do with my day, I might have a hundred different options. But when I choose to go to the park, there’s only one option that consists of what I would have done otherwise. Maybe I would have taken a nap. That’s the cost. The opportunity cost of me going to the park is foregoing one nap while gaining a park walk. It’s not me travelling all over the world or writing some classic work of fiction. Maybe those are better conceivable uses of my time than napping, but those are not what would have transpired and therefore they are not the relevant counterfactual for comparison.
This “would have vs. could have” ambiguity was written about clearly in the early writings of Martin Feldstein. All these years later, I suspect opportunity cost continues to create confusion because the models economists employ assume conditions of optimality. In such models, the most likely alternative to some state of affairs is the next best optimum. But in the messy real world, with all its flaws and imperfections, what would have happened otherwise is not the very best alternative.
In this sense, the famous quote from Milton Friedman that, “there is no such thing as a free lunch” is not really correct. Free lunches are everywhere. When a regulator engages in a review of his existing rules to assess their effectiveness, the opportunity cost of his time may well be that he would have used it to issue yet another inefficient rule. In that case, the review is better than a free lunch. Society is better off by one fewer bad regulation, even if the review itself achieves no benefits.
Finally, with respect to the claim that I supposedly think “radical subjectivism commits one to a rosy view of government policies,” I would put it slightly differently. There is an important role for economists to play in measuring costs. Without solid costs estimates, all manner of terrible public policies are likely to be enacted that we might not get if the costs were made transparent. In my experience, many Austrians consider such endeavors a waste of time. (In this respect, Buchanan’s advice to economists may be yet another area where he has helped lead Austrians astray. But alas, that is a topic for another day.)
If there is a danger of a particular view of cost threatening our liberties, it comes from those who downplay the importance of costs by portraying them as merely psychological and who discourage talented individuals from engaging in cost measurement. Costs involve all too real consequences. Fortunately, economists have the tools they need to cast a light on the unseen.
James Broughel is a Senior Fellow at the Competitive Enterprise Institute with a focus on innovation and dynamism.
READER COMMENTS
John Hall
Oct 4 2023 at 2:21pm
On your definition of opportunity cost, I recall some kind of survey that was distributed to professors that asked them an opportunity cost question that they got wrong in much higher numbers than people would have expected. I always thought the definition was a little unclear in most textbooks. My recollection is that your definition was much closer to what was intended on this survey.
Anyway, one qualification with your conception of opportunity cost is that it expresses the costs in terms of units of a good (or presumably a service), rather than something like utility. The Austrians tend to think of costs more in utility terms. That being said, it’s been many years since I’ve read Mises/Rothbard, so I can’t remember how the Austrians reconcile their version of opportunity cost with ordinal utility. For instance, you say “The opportunity cost of me going to the park is foregoing one nap” but isn’t your definition above that it should be the difference between going to the park and having a nap. How do you subtract them without some kind of cardinal utility?
A more sophisticated approach to opportunity cost would also incorporate uncertainty.
James Broughel
Oct 4 2023 at 4:51pm
This is a great point Josh. I suppose I was thinking of “costs” as negative opportunity costs when I wrote that sentence. Technically, both costs and benefits should be valued according to opportunity cost. Thus, the cost is foregoing a nap, while the benefit is a walk in the park. The net effect would be the overall opportunity cost.
One can net out costs and benefits or add the dimension of uncertainty and maintain an ordinal measure of utility. I think there is no problem with either my version or the Austrian version of cost in this regard. (Perhaps Austrians are thinking of cost as a discounted projection of lifetime utility, or something similar, which would be instantaneous.) But utility is only one scale of measurement, as there are many others. We could grade benefits and costs in dollars for example, or use some social welfare function.
James Broughel
Oct 5 2023 at 11:53am
I added a small edit to the piece in light of your helpful feedback, Josh. That sentence now reads:
“The opportunity cost of me going to the park is foregoing one nap while gaining a park walk.”
What gets counted as a “cost” vs. a “benefit” is somewhat subjective, but the sum total of the nap and the park walk would be the total opportunity cost of walking in the park vs. staying home and sleeping.
Michael Giberson
Oct 5 2023 at 7:04pm
You are thinking of Ferraro, P. J., and L. O. Taylor. 2005. “Do economists recognize an opportunity cost when they see one? A dismal performance from the dismal science.” Contributions to Economic Analysis & Policy 4(1 ):7.
Joel Potter and Shane Sanders argue that the Ferraro and Taylor question is underspecified in ways that leave several of the answers reasonable. See: Potter and Sanders, “Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance or an Arbitrary Concept?” Southern Economic Journal, 79(2):248.
The issue was pursued in various other journals. See Stone, Daniel F. “Clarifying (opportunity) costs.” The American Economist 60(1):20.
David Seltzer
Oct 4 2023 at 4:00pm
James, thoughtful meditation. “there is no such thing as a free lunch” is not really correct. Free lunches are everywhere. Just spit balling; doesn’t the mere exercise of thinking support Friedman? Time is consumed when thinking and that interval of time cannot be recovered. Hence an opportunity cost in terms of a valuable resource.
James Broughel
Oct 4 2023 at 6:25pm
Thanks for this comment. I suppose there may always be some benefit foregone, even if only to particular individuals. If a terrorist is plotting an attack, and something prevents this, that feels like pretty close to a free lunch. But yes, I suppose we have to take into account the benefit to the terrorist.
Dylan
Oct 4 2023 at 5:23pm
There was a recent post on opportunity costs that made this distinction, but it seems weird to me. There’s no real way to know that you would have taken a nap if you hadn’t gone to the park. Counterfactuals are inherently unknowable. There are at least a dozen plausible things I could be doing right now if I wasn’t writing this comment. Maybe I’d be reading another blog, or commenting on one, or checking my email, or making a snack, watching a movie, or perehaps even doing something productive with my time. If we believe in infinite universes, there exists one for each of those options and also for the one where I drop everything and go to the airport and take the first flight to Prague. Which one counts as the real opportunity cost and how do I figure that out?
James Broughel
Oct 4 2023 at 6:38pm
I didn’t say it was easy to figure out, just that there is some objective counterfactual. Businesses actually engage in this practice all the time. They discount cash flows on the assumption that in absence of undertaking some investment they’d be earning some rate of return in the counterfactual. I think that’s a good place to start.
Dylan
Oct 4 2023 at 7:08pm
Interesting choice of example, I used to do just this kind of analysis for our clients when evaluating M&A opportunities. Two things I learned.
1) Not a single company ever properly calculated their discount rate in the way that finance textbooks said they should. It was almost always a number more or less pulled out of thin air because that was the discount rate they had always used.
2) More relevant to this discussion, when investigating an M&A target, it was not enough for it to be NPV positive, but it had to be the best possible opportunity out of all the opportunities out there. My company was retained because company management had found an attractive target that met the internal criteria for acquisition, but the board would push back because they hadn’t compared it to all the other options out there. Obviously, there’s a feasible upper bound to how many options you can look at, but my job was often to compare not one choice to the next best option, but to compare each to hundreds of others.
Jon Murphy
Oct 6 2023 at 8:04am
That’s why costs are a psychological phenomenon. They require one to evaluate what she or she perceives as the viable alternative(s) and their relative probabilities. Any time one makes a counterfactural claim, it requires some level of judgement, which is consequesntly psychological.
Counterfactuals are unknowable. But that doesn’t mean they do not exist.
Dylan
Oct 6 2023 at 3:53pm
Sure, they exist, but I’m not always sure that they’re worth paying all that much attention to. In some cases, it is easy, like “I’m going to park my measure in treasuries unless you show me something that has a better return, and then I’ll do that thing.” Other times it can be more like, “let’s look at all possible options for this money, and then I’ll pick the absolutely best option” and then, 18 months later “we’ve found the best possible option…oops, that opportunity is no longer available.”
The latter is what a lot of my time in the corporate world have looked like. Lots of looking at things, very little actual doing. And, of course the same thing happens at the individual level, decision paralysis is a real thing.
I’m kind of thinking that the mass-men might have it more figured out. The unexamined life is the one where you actually live.
Jon Murphy
Oct 6 2023 at 6:10pm
I don’t understand your point. Your second example is no different from your first. Both have foregone benefits, which are costs.
Jon Murphy
Oct 4 2023 at 5:30pm
James-
I am having a real hard time seeing how you come to the conclusions you do from reading Buchanan. I’ve reread Cost and Choice, in particular Chapter 3 multiple times since your original post, and I just don’t see the conclusions you draw. Can you provide quotes from Buchanan that support your argument? I’m just not seeing it.
James Broughel
Oct 4 2023 at 6:35pm
Sure. The quote below is pertinent. I would also reiterate that I think Buchanan had a multifaceted view of cost. But this passage gets at the crux of his subjectivist argument, which is what many Austrians seem to have clung on to:
“1. 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.
2. Cost is subjective; it exists in the mind of the decision-maker and nowhere
else.
3. Cost is based on anticipations; it is necessarily a forward-looking or ex
ante concept.
4. Cost can never be realized because of the fact of choice itself: that which is
given up cannot be enjoyed.
5. Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
6. Finally, cost can be dated at the moment of decision or choice.”
From my perspective, this is all a description of choice, not cost.
Jon Murphy
Oct 5 2023 at 9:12am
The following paragraphs after that list answer your objections, though (or, at least attempt to). See especially his part about about choice-influencing and choice-influenced cost.
robc
Oct 5 2023 at 12:10pm
I think that aligned properly with your napping example, which is an opportunity cost.
The cost of going to the park is not napping.
How does that cost fit with Buchanan?
-Its born by the decision maker
-It exists in your mind
-You anticipate the nap, or potential nap
-It cannot be enjoyed, you gave it up
-I cannot measure the value of your nap
-Its time is when you decide to go to the park instead
6 out of 6. I don’t understand your issue with Buchanan, you seem to agree with him fully.
Jon Murphy
Oct 6 2023 at 9:17am
I think there might be some disagreement on how Buchanan (and the LSE school more broadly) use the phrase “subjective” and “psychological” (might as well toss Thirlby’s “ephemeral” in there too). That costs (and benefits) are subjective and psychological does not imply they are unmeasurable. I understood those words to mean the whole exercise of evaluation is contained within the individual (the subject) rather than the thing (the object).
For example, James and I made the same decision: we both opted to go to GMU for grad school (the object). We took (in all likelihood) the same classes from the same professors. We invested similar amounts of time. But our evaluation of those costs will be radically different. I do not know what margins James was adjusting along but I am 100% sure they were not the same as mine (I was debating GMU or seminary). How we weighed the various costs (what we had to give up) is an imagnative exercise. We can still put numbers on these costs (tuition, foregone salary, etc)., but it is still ultimately psychological. That doesn’t mean those numbers are pointless or arbitrary. Rather, that they are contained and evaluated by the subject (thus subjective) rather than contained within the object (thus objective).
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