June 30, 2019

Opportunity cost ― another case of poor economic logic

Comment on John Quiggin on ‘Opportunity cost, MMT and public spending’*

Blog-Reference and Blog-Reference (Link)

Wikipedia says: “In microeconomic theory, the opportunity cost, or alternative cost, of making a particular choice is the value of the most valuable choice out of those that were not taken. In other words, opportunity that will require sacrifices. When an option is chosen from two mutually exclusive alternatives, the opportunity cost is the ‘cost’ incurred by not enjoying the benefit associated with the alternative choice. The New Oxford American Dictionary defines it as ‘the loss of potential gain from other alternatives when one alternative is chosen’. Opportunity cost is a key concept in economics, and has been described as expressing ‘the basic relationship between scarcity and choice’.” and “Thus opportunity cost requires sacrifices. If there is no sacrifice involved in a decision, there will be no opportunity cost. In this regard the opportunity costs not involving cash flows are not recorded in the books of accounts, but they are important considerations in business decisions.” and “The term was first used in 1894 by David L. Green in an article in the Quarterly Journal of Economics entitled ‘Pain Cost and Opportunity-Cost’.#1

It is pretty obvious from the sacrifice and pain verbiage that opportunity cost is a concept from and for mentally retarded masochists. So, let us get rid of folk psychology and rethink the objective economics of social choice. Because economics is NOT psychology what is needed first is a description of the monetary economy as a whole.

The elementary production-consumption economy is defined with this set of macroeconomic axioms: (A0) The economy consists of the household and the business sector which, in turn, consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market clearing X=O and budget balancing C=Yw in each period, the price as the dependent variable is given by P=W/R. This is the macroeconomic Law of Supply and Demand. For the graphical representation see Wikimedia.#2

So, to begin with, there is not much choice. The elementary production-consumption economy produces one consumption good which is fully consumed in the period under consideration. Total labor input L is given. Macroeconomic profit is zero.

The price P is objectively determined by the wage rate W, which takes the role of the nominal numéraire, and the productivity R. The macroeconomic Law of Supply and Demand contains NO subjective element at all.

What about the subjective side? The workers would not spend their wage income C=Yw on the firm’s output if the product had no “utility” for them. Let us assume the economy consists of 1000 workers, then each one has a positive “utility” but since subjective “utility” is neither measurable nor comparable we are already here at the end of the road.

It is necessary that the workers translate their subjective “utility” into an objective reservation price P'. The subjective condition for buying the output of the firm is that the reservation price is higher than or at least equal to the market price, i.e. P'≥P. Choice is binary: buy if P'≥P otherwise do not buy. From the fact that all 1000 workers have bought the output, i.e. X=O, one can then conclude that their subjective reservation prices have at least been equal to the market price. The difference between the subjective reservation price and the objective market price, i.e. P'−P, is the subjective consumer rent per unit of output.

As a result, the elementary production-consumption economy is objectively and subjectively reproducible for the time being. Needless to emphasize that reservation prices can change quickly, after all, they are only in the head.

Now, the business sector invents a second product that is minimally different from the first. Say, product 1 has lemon taste and 2 has orange taste, otherwise, they are identical. Let us assume the business sector makes market research and finds out that 500 workers prefer the new product the others stay with lemon taste. The business sector adapts production accordingly.

The production alternatives follow with fixed total employment, i.e. L=L1+L2, directly from the axioms and are given by O1=R1L−R1/R2 O2. For the graphical representation see Wikimedia.#2

In the initial period with only one product, the economy was at the position A. After the introduction of the second product the economy is at position B. The economy disappears at A and reappears in the next period at B, it does NOT move from A to B. Total employment, wage rate, total wage income, productivities, etc. remain unchanged, the only thing that is different is the composition of output. The respective prices are Pl=W/R1 and Po=W/R2 with R1 and R2 equal for simplicity.

The subjective valuation of the lemon-taste group remains unchanged, all individual reference prices Pl' with Pl'≥Pl (= buy) from 1 to 500 stay put and the reference price for the new product is Po'<Po (= don’t buy).

The subjective valuation of the orange-taste group is accordingly Po'≥Po (= buy) from 501 to 1000 and Pl'<Pl (= don’t buy) for the lemon taste product which was in the initial period valued with Pl'≥Pl.

So, the new output combination has a higher total subjective value than the old because the orange-taste group attaches a higher subjective value to the new product while the lemon-taste group stays put. Total labor input remains the same. It can be said that the additional option increases subjective value for the economy as a whole under the condition that both the firm and the workers are indifferent about whether lemon-taste or orange-taste output is produced.

The crucial point is that the orange-taste group sacrifices NOTHING because the old product is simply replaced by a new product with a higher subjective value. The economy as a whole jumps from a lower subjective valuation of total output to a higher subjective valuation of the new composition of total output. The switch from A to B involves NO sacrifice but increases total subjective value because the new product suits part of workers/consumers better.

Where, then, does the sacrifice thinking come from and why is it so plausible? Imagine a boy is sent to the supermarket with one dollar to buy a pot of yogurt for himself. The boy is confronted with the choice between strawberry and raspberry yogurt but cannot decide. So, he takes both, that is he enriches himself temporarily. The store manager makes it clear to him that with one dollar he can have only one pot and that he has to give back the other. This makes the boy think that choice involves a sacrifice. This sacrifice, though, is only imaginary. Generally speaking, sacrifice thinking comes from people who erroneously think that the best solution to the choice problem is to have both alternatives. For children this is natural, for grown-ups it is sociopathic.

Society can choose between A and B but with the choice of the subjectively better alternative, NO sacrifice is involved. The choice of B makes A impossible and the subjective value of A is, therefore, uno actu zero. What has no value cannot be sacrificed.

Egmont Kakarot-Handtke

* Crooked Timber
#1 Wikipedia Opportunity cost
#2 Wikimedia AXEC31 Elementary production-consumption economy
#3 Wikimedia AXEC154a Production alternatives

Related 'For MMT = For the Oligarchy' and 'No MMT illusions! YOU are going to pay for it' and 'MMT and the Green New Deal: Where is the snag? (I)' and 'The half-truths and half-falsehoods of MMT'.