Have you ever experienced something like this? You are somewhere you’ve never been before, perhaps on vacation, and you imagine what it would be like living there permanently. Country life on a farm in Tuscany. On an island in the North Sea. In Downtown Manhattan.
I think like that all the time. As soon as I am in a new place, I think about what it would be like to live there. What I would do for a living, what my apartment would look like, and whom I could and would get along with.
Much to my surprise, I often can well imagine living elsewhere. At least until I start thinking about what I would have to give up for it. Life in the big city of Berlin. My mother tongue. Friends.
After I’ve weighed it up, I’m usually happy the way it is.
I’m telling this because economics, at its core, holds a pearl of wisdom. It’s the realisation that you can’t have everything. Not every goal can be achieved, and not every wish can be fulfilled. It’s not up to us, it’s just natural.
Scarcity is at the core of economic theory. It makes economic action necessary in the first place. We must spend part of our lifetime working to have enough money to live. We are constantly thinking of refining our work to reduce scarcity (for example, think of all the advances in farming over the last 100 years). And above all, we constantly have to choose between alternatives.
When we ask ourselves how much time to spend working, we face a trade-off between more free time and more income. When we want a new sofa and a vacation in Canada, but the money in the bank account is enough for only one, we have to decide. And when we value single life but also want offspring, there is (probably) also a choice to be made.
Economics has come up with the concept of opportunity costs for this. Opportunity costs describe the unavoidable trade-offs in the presence of scarcity: satisfying one objective more means satisfying other objectives less.
The concept of opportunity costs can explain a lot. For example, differences in the hours that people work throughout history.
The Industrial Revolution has been accompanied by a dramatic rise in wages. The average real hourly earnings of American workers did increase more than six-fold during the twentieth century (I took this example from here). At the same time, working hours were reduced. So in most societies, technological progress was split into two parts: more income and more free time.
Obviously there is a desire not only to earn more, but also to enjoy more free time instead of earning more.
So far, so (hopefully) understandable.
But the idea of opportunity costs has another piece of wisdom that can explain seemingly strange individual decisions.
The theoretical thought behind it: When we consider the cost of taking action A we include the fact that if we do A, we cannot do B. So ‘not doing B’ becomes part of the cost of doing A. This is called, as said above, opportunity cost because doing A means forgoing the opportunity to do B.
Imagine that an accountant and an economist have been asked to report the cost of going to a concert, A, in a theatre, which has a $25 admission cost. In a nearby park there is concert B, which is free but happens at the same time.
ACCOUNT: The cost of concert A is your ‘out-of-pocket’ cost: you paid $25 for a ticket, so the cost is $25.
ECONOMIST: But what do you have to give up to go to concert A? You give up $25, plus the enjoyment of the free concert in the park. So the cost of concert A for you is the out-of-pocket cost plus the opportunity cost.
Suppose that the most you would have been willing to pay to attend the free concert in the park (if it wasn’t free) was $15. The benefit of your next best alternative to concert A would be $15 of enjoyment in the park. This is the opportunity cost of going to concert A.
So the total economic cost of concert A is $25 + $15 = $40. If the pleasure you anticipate from being at concert A is greater than the economic cost, say $50, then you will forego concert B and buy a ticket to the theatre. On the other hand, if you anticipate $35 worth of pleasure from concert A, then the economic cost of $40 means you will not choose to go to the theatre. In simple terms, given that you have to pay $25 for the ticket, you will instead opt for concert B, pocketing the $25 to spend on other things and enjoying $15 worth of benefit from the free park concert.
Why don’t accountants think this way? Because it is not their job. Accountants are paid to keep track of money, not to provide decision rules on how to choose among alternatives, some of which do not have a stated price. But making sensible decisions and predicting how sensible people will make decisions involve more than keeping track of money.
An accountant might argue that the park concert is irrelevant:
ACCOUNTANT: Whether or not there is a free park concert does not affect the cost of going to the concert A. The cost to you is always $25.
ECONOMIST: But whether or not there is a free park concert can affect whether you go to concert A or not, because it changes your available options. If your enjoyment from A is $35 and your next best alternative is staying at home, with enjoyment of $0, you will choose concert A. However, if concert B is available, you will choose it over A.
So, thinking like an economist does not only mean thinking in terms of shortages (e.g. money, time) but also being aware that almost every decision blocks another possibility.
Why is this important? Because that’s the only way we can understand why people make the decisions they make. You can’t just single out one decision. That leads to misunderstanding. People act in networked contexts.
Also, when it comes to the question of whether I would like to live in the countryside (I often find myself confronted with this question as I often hike through the countryside of the state of Brandenburg that surrounds Berlin, where I live). The answer I give myself is always the same: Yes, but rather not. That answer shouldn’t bother me. I can’t have everything. It’s in the nature of things.