ALL COSTS ARE OPPORTUNITY COSTS: shall I buy that pair of shoes or pay down some debt?

All costs are what? Who says so?

I’ve recently started reading books about economics. OK, OK, I know: I’m a sad person, I should get out more.

But it happens that I do get out a lot. Everywhere I go, and everything I read, reminds me that I don’t know enough about the theory and practice of economics, the so-called “dismal science” that underpins our society. Hence my decision on reading matter.

Luckily, the first book I found in my local library’s very small economics section was called “The Instant Economist”, by an American professor called Timothy Taylor. Luckily, because this book is so clear and so well written. The back-cover blurb says “the only economics book you’ll ever need”. That’s quite a selling point.

All costs are opportunity costs: what does that mean?

Prof Taylor gives this simple example. Suppose you are thinking of having your house cleaned in future, rather than doing it yourself. You’ve researched it and find it will cost you $300 per month, i.e. $3600 per year. But instead of thinking of just that figure, think of what else the money could buy. His example was a holiday in Mexico. You might change the destination if you lived in Europe (or you were already located inMexico) but you get the point. That holiday is the opportunity cost. Or, as he puts it, the true cost is not the money you spend (and $3600 is “just a number”) but the thing(s) you give up.

Here’s Wikipedia’s definition:

Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

Is that assertion qualified by an assumption?

Well, I’m no economist (yet) but I think it must presuppose that resources are limited. But that’s no problem, because they almost always are.

Any other examples?

Yes indeed. I’m planning a party this year to celebrate a significant birthday. (since you ask, I’ll be 40. Again).

A couple of weeks ago, I got enthusiastic about a certain venue that seemed perfect; great environment, wonderful location. Then I found out the cost: over £1000 to hire the venue, excluding catering and booze.  That should have ruled it out immediately but I’d already fallen in love with the idea. I thought “That’s expensive but maybe I can find that.” The money could have been found (and justified to myself!), but I didn’t think about the opportunity cost.

It was brought home to me by a friend (a very good friend, as this example proves) who said “Michael, you don’t need to spend that much. Your friends don’t need to be in a fancy place to enjoy a party (never a truer word was spoken), so why not find a cheap venue and spend the rest of that money on giving yourself a nice holiday?”

She was right; I could have that holiday, or give the money I might have spent to my daughters, to help them with a deposit on a flat. Opportunity cost again.

Any examples in the news?

Here in the UK, the cover story in my paper today (29 Jan 2013) is rail investment; the front page headline is “North and south unite against HS2.” If you live in the UK, you’ll know that HS2 is the planned new high-speed rail link; today’s news is that the routes for Part 2 of the project have been announced, linking Birmingham with Leeds and Manchester at a planned cost of £30+ billion.

There are environmental objections, of course, and these will probably delay commencement of work for ten years. But there are other objections, especially this: if the aim is to “spread the UK’s wealth”, as claimed, are there better ways of spending £30bn? Especially in a situation where many parts of the existing rail network are of third-world standard.

So, again, opportunity cost is the way to think of this issue. It’s about choices.

So what’s the connection with Back to the Black?

I’m glad you asked. It’s in Chapter 7, where I discuss discretionary income, i.e. what’s left after taxes, utilities and other essential costs. What you are left with is available for discretionary spending (i.e. on non-essentials) … or for paying down debt. Here’s an extract:

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The Oxford English Dictionary defines that part of a person’s income remaining after essential living costs as “discretionary income”; however, you’ll often find the term “disposable income” used for the same purpose. Strictly speaking, though (again according to the OED), disposable income is simply gross income minus tax.

These days the two terms are used interchangeably – especially in the UK – for what we’re discussing here. I prefer the term “discretionary”; it’s a good description because these are the funds over whose use you have “discretion”, i.e. you are the decision-maker. You, and no-one else, can decide how much of your discretionary income you’ll spend on non-essentials and how much is available to pay down debt.

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Thus, as I said at the top of this piece, “all costs are opportunity costs.” It’s apparently a key principle in economics; but it also has very practical applications in our daily lives.

It’s all about choice.

 

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