'Cost' means what, exactly?

'Cost' is the opportunity that you have to give up in order to do something else. But how can this concept be measured in dollars?

A couple of days ago, I wrote about prices, profits, and losses in the context of the Styrofoam-or-paper debate. Yesterday, we covered cost and supply in econ 100. Here is an email I sent to my students this morning that addresses the question of measuring costs using dollars and cents. One of the best treatments of the cost concept is James Buchanan’s Cost and Choice. Here’s the email:

Here are a few quick thoughts on the use of dollars and cents to measure opportunity cost. They’re a little beyond what we’re doing this semester, they won’t be on any of the tests, and they will likely reappear in more formal fashion in intermediate microeconomics, but I thought that some of you might be interested:

When we talk about “cost,” we’re talking about something subjective: a cost is the next-best opportunity that you have to forgo in order to do something. Since cost is subjective, how do we get away with expressing cost in terms of money?

Using dollars and cents to approximate costs is actually more sound than it might appear to be at first. The market’s process of buying and selling generates market prices for things like corn, potatoes, textbooks—and labor of different kinds.

We hypothesized yesterday that if the going you are each giving up the opportunity to work for wages in order to come to class. If you could have earned $8/hour, then going to class for 75 minutes cost you $10 in foregone wages.

You might respond “but what if my next best opportunity is sleep, studying for another class, or playing video games rather than working? How do you get away with the ‘$10 cost’ statement?”

That’s a good question, and it illustrates that the cost we are estimating is at best a minimum cost: we know that the cost to you of going to class is at least $10 even if there are a lot of activities between “going to class” and “working for wages” that you prefer to “working for wages.” Since we can observe market prices for different types of labor, and since most labor markets are extremely competitive, we can be pretty sure that going to class costs you at least $10. Suppose you rank the different uses of the 75 minutes between 2 and 3:15 as follows:

1. Go to Econ 100 (I’m flattered)

2. Sleep

3. Play video games

4. Watch paint dry

5. Work for $10

Value is subjective, so we can’t assign numbers that tell us anything about how much you value options 1-4; i.e., we can’t say that “Econ 100 gives you two gallons of happy while sleep only gives you 1.5 gallons of happy.” We can, however, observe the market price of labor and say that by going to class, you are giving up—at the very least—the opportunity to earn $10.

As this course is an introduction to economics, there are all sorts of interesting (?) details we will have to skip over. A few weeks ago, I sent you links to Ludwig von Mises’s Human Action and Murray Rothbard’s Man, Economy, and State, which provide unique and somewhat non-traditional approaches to economic thinking. Stephen Landsburg’s The Armchair Economist (which isn’t free online, unfortunately) provides a very good discussion of basic economics and might be a worthy addition to your nightstand.

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