Three Kinds of Cost
Previous: Scarcity Is the Presence of Choice
Is there such a thing as a free lunch?
It’s not a trick question. Literally, can you have a free lunch?
It’s certainly possible to have a lunch you don’t have to spend money on, at least in the most direct sense. But it’s easier said than done. If you have to drive there, you’re spending money on gas eventually. If it’s a classy affair, maybe you need to buy a new pair of shoes or a tie that matches your shirt.
And lunches aren’t risky, but that doesn’t mean there’s no risk. It’s not impossible that you could lose your wallet. The probability isn’t zero, and so you might expect to lose, say, $0.000005 at every “free” lunch.
And when you’re at that “free” lunch, presumably you’re not working. You could be making money, and you’re not. Even though it’s invisible and indirect, you’re forgoing money to have this lunch.
And never mind trying to figure out how to have lunch without spending time or energy on it!
What does it mean to spend? It’s a word bandied about so casually. But what does it mean?
Suppose you’re fumbling with your change, and you accidentally drop a coin. Now you’re 25 cents poorer, just as if you had bought a gumball. Did you “spend” 25 cents?
That certainly doesn’t feel right.
Suppose you get a ticket every day to eat at a cafeteria. There’s nothing else you can do with the ticket. It’s coded to your DNA, so you can’t trade it. It’s ugly, so it’s not worth looking at. It has no sentimental value. The only value it brings you is that you have to have to give it to the person behind the counter before you can get your food.
You spend that ticket. I think that’s fair to say. But suppose one day the cafeteria decides you don’t need a ticket to get in. Now you don’t need to spend anything to eat there. Does that change your choices?
It could. Maybe you’ll have two meals there a day, or seven. Maybe too many people will want to eat there now. But let’s hold how much everyone, including you, wants to eat there constant. Or, let’s say you need tickets again to eat there, but the cafeteria is always crowded anyway, and, more importantly, every time you want another meal there you can just get a ticket or three as you walk inside, or we could just say that the ticket can’t be saved, so that you either spend it in the moment or might as well throw it away.
Whether we held the cafeteria’s conditions constant or let them slide, does it seem like it matters whether you personally have to spend a ticket to eat a meal there, as long as every time you want another meal, a ticket is available?
...No. As long as the ticket is useless for anything but getting into the cafeteria, that is, as long as it has no alternative uses, a situation where you have to give one up to do something should be the same as just choosing to do that same thing.
So do you spend a ticket to get a meal? Sort of. You willingly give one up, and that’s kind of like spending. But in another sense, not really. “Spending” the ticket, as in, the mere fact that the ticket has to be given up, is irrelevant to your choices. Knowing you have to spend this ticket doesn’t help an economist predict your behavior.
What is a sense of “spend” that is more meaningful? What kind of spending actually distinguishes between spenders and nonspenders?
Let’s go back to the cafeteria, only this time, instead of having to “spend” an otherwise useless ticket to get in, now you have to spend money.
Now we can tell the difference between spenders and nonspenders; the spenders are the ones eating!
What’s the difference between money and a ticket? Why does spending money, but not a ticket, change behavior?
This: money has alternative uses, and the ticket doesn’t.
The ticket was only useful to get into the cafeteria. Since you could get a ticket whenever you wanted a meal, it wasn’t even a matter of when you wanted to eat. There was never a reason not to give up a ticket. You would have torn up a dozen of them for your own amusement. But something tells me that even a millionaire might have a hard time tearing up twelve dollars.
Money has alternative uses. Anything that doesn’t have alternative uses isn’t worthy of the name. Money that you spend on a meal at the cafeteria is money you can’t spend on a meal elsewhere, or on groceries, or on a movie, or on a car, or medicine, or clothes, or….
You can buy a lot of things with money. And that means every dime you spend on a meal at the cafeteria is a dime that can’t be spent on other things. The true cost of the meal at the cafeteria is the value you have to forgo in order to get it.
We’ve distinguished between three kinds of spending: losing something, like when you drop your change; inputting something, like when you have to give up a ticket to get a meal; and forgoing something, like when you spend money and give up the alternative value it could have purchased.
Let’s go back to the 25 cents you lost while fumbling for your change and the gumball you could have bought with the money. That loss harms you; it might even cause you pain.
Do you pick the money back up?
To pick the money up requires you to bend over, look around. You have to input time, energy, and focus to find your money. Your clothes might get wet or dirty, essentially an input of clean clothes.
Do you do so?
To do so means making a choice to retrieve the money. You’ll have to bend over, look around. You have to input time, energy and focus, which have alternative uses, to find your money. Your clothes might get wet or dirty, but you could choose for them not to be.
Now do you pick the money up or not?
Knowing how much the loss of 25 cents harms you is not enough for us to answer that question. What is relevant to your choice is whether what you have to spend to retrieve the money is greater than what you spend in not retrieving the money. Suppose instead of having lost 25 cents, you see 25 cents just laying on the ground. Is the question of whether you pick it up very different here, even though in one scenario you were harmed and in the other you were not?
Knowing what kinds of inputs or outlays are required to retrieve the 25 cents is not enough for us to answer the question of whether you pick up the money. The mere fact that you must give up energy to retrieve the money will not affect your choice if your energy had no alternative use. If you think about what it means for your energy to have no alternative use, this will seem like a truism.
Knowing what alternative opportunity you forgo by choosing to retrieve the 25 cents does allow us to take a pretty good guess whether you will pick up the money. If the value of what you spend in retrieving the money is not as great as the value you could have reaped had you spent your time, energy and so on on some other alternative, then you probably won’t pick up the money. If your time is so valuable, or you so value having clean clothes, or you prefer the alternative where your knees don’t hurt from bending, then you won’t pick up the money.
When we removed sand so we could fit the rest into the hole, we had to leave some sand behind. That sand we left behind is called a cost. Costs can be divided into three parts.
1) Some of the sand spontaneously falls off the sphere. This is called pain or harm cost, and it is when bad things happen to you that you don’t want to happen, like dropping 25 cents. Stubbing your toe harms you. Getting stuck in traffic harms you.
2) A particular grain of sand has to be taken off the sphere and put into some kind of slot in order for the hole to open, as if you’re playing a puzzle game. This cost is called accounting cost. It is an outlay, some kind of input required to receive an output, like when you have to give up a ticket to get a meal at a cafeteria. The coins you have to put into a slot machine are an outlay. The time you have to spend waiting for your leftovers to reheat is an outlay. It’s called accounting cost because it is the kind of cost accountants write down in their books: “$5 was spent today on such-and-such.” I will also call it outlay cost.
3) You make a choice to remove some of the sand so the rest can fit. This is called opportunity cost. This is a less material kind of cost. It is subjective and happens in the brain. Opportunity cost is the value of the next-best choice, which you had to forgo to make the better choice. The value of clean pants when you get on your knees to retrieve your money is an opportunity cost. If you order the chocolate ice cream, passing over the vanilla, then the foregone value of ordering the vanilla ice cream is the opportunity cost. If you choose to go see a basketball game rather than watch a movie, the opportunity cost is the foregone value you would have reaped from seeing the movie.
And, as we have seen, of the three kinds of cost, only opportunity cost predicts choice.
Next: More on opportunity cost and its intimate relationship with scarcity....
This article is a great hands on demonstration regarding the opportunity cost of of reading 1,600 words explaining what Wikipedia can in less than 100.
The Wikipedia article, while quite good for a Wikipedia article about economics, tells you nothing about the distinction between opportunity cost, harm cost, and outlay cost, and I would confidently predict that you would quickly mix up the three given an opportunity to do so. You would also predict action based on harm cost and outlay cost. Have seen it many times, it’s why I wrote an article about it.
But as long as you don’t know this, you won’t know that you don’t know it.
And it’s frankly an idiotic thing to say. The whole point of writing this way is to convey an experience so that the lesson is learned more deeply than just memorizing some definition out of an encyclopedia article. The latter is better for regurgitating on a test, the former better for actual application and use.
Wouldn’t that be an alternative use?
Good question, but not exactly right, because tearing up a dozen of them doesn’t forgo any alternative. So you can tear up the tickets, and then you will have another to spend on a meal anyway. No opportunity is closed off to you, and therefore tearing up the ticket is not an alternative use, unless you are partial to a particular ticket for some reason. Think about it, if you have alternative A and alternative B, and choosing alternative A does not in some sense forgo alternative B, in what sense are they alternative? Could call them single alternative AB with absolutely no change in your expectations, yet tearing them up no longer even feels like an alternative use since it is the only use.
Of course, the time, energy, effort, and concentration you spend tearing up the tickets have alternative uses.
Warning: This article contains talk of what words mean, but is not really the point. The sound and particular grouping and ordering of letters used to convey the concept are irrelevant to my point. The point is to understand the concept, idea, sensation and expectation that am trying to communicate…will also mention the virtue of not fighting the hypothetical.
Shouldn’t this sort of disclaimer be in the post itself?
No, should be technique student has already learned. Teacher’s intention not even relevant. Goal should be to extract as much value as possible from teacher for personal growth. This is website devoted to rationality; if I thought I had to explain how to engage with a text, I wouldn’t have come here.