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Why It's Important to Understand "Economic Costs"

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Tags Austrian Economics OverviewSubjectivismValue and Exchange

06/20/2019

The concept of economic cost seems to confuse people. It is not the price you pay for a good, but the reason you pay it.

The cost of one action is the value you could otherwise have gained from taking another action. In other words, if you have $100 and you have the choice to buy two goods, each at a price of $100, you'll naturally choose whichever is more important (valuable) to you. The cost of it is not the $100, which you give up to purchase it, but the value of the other good, which you can no longer purchase. That other good is the opportunity foregone by your action, the true cost of your action the economic cost.

Why does this matter? Because our actions are intended to create value, and we always aim to maximize that (subjectively understood) value. The economic cost concept brings to our attention what we actually give up to get a value, and thus why we choose a certain course of action.

An economy, which is a system of economizing on scarce resources, is the systematic allocation of resources to maximize value. It is not about minimizing the price paid, which is something different. It is about value. While this may seem like an academic point, the implications are enormous.

Those who are ignorant of this concept focus on the outcome of action only — the "net gain" — rather than the cost. Doing so means we end up wasting enormous resources while not getting the value that was well within reach.

Examples of this include arguing that there were massive gains from, for example, World War II or the US space program in the 1960s. Both were enormously wasteful, but also generated tangible benefits. WWII led to the discovery of artificial rubber, freeing us from costly and time-consuming rubber production. Yes, that's a benefit. And there were plenty of technologies developed as part of the space program. Those were also benefits. But at what economic cost? That's the real issue: what other benefits did we never see because we instead pumped in enormous resources into war and the space race? What other discoveries and innovations were within reach had those resources been used differently?

The WWII example should be obvious, since the war itself was hardly productive. But the space program is exactly the same issue: what opportunities did we, as a society, forego because the government preferred to invest billions of dollars into the prestige program of beating the Russians to the moon? We don't know what we didn't get, of course.

But this doesn't mean we cannot say whether it was the right thing to do. The fact is that in a market system entrepreneurs compete with each other not to minimize cost, but to produce value. Naturally, this means net value: what actual benefit is provided in the eyes of the consumer. The entrepreneurs don't know what consumers will value, but they bet their livelihoods on what they think will benefit consumers most. The result is a variety of goods and services from which consumers can choose, and they will choose what is the best option from their point of view. What is not produced cannot be chosen. But what is not produced also does not seem to be worth it to the numerous entrepreneurs engaging in value facilitation for consumers.

Note that this is not a matter of whether entrepreneurs can "afford" the capital investment needed. It is about the rate of return: whether the value is high enough above the outlays necessary to produce the good/service (the production cost). With a sufficiently high ROI (return on investment), relative to other possible and attempted projects, entrepreneurs can always find the funds needed: investors are looking for a return on their funds, after all.

So the argument that "only the government can" invest in something because it requires capital is bogus. It asserts problems that don't exist, and often fails to properly apply the concept of economic cost (as in the examples above). Economic cost tells us what is expectedly most important to people, regardless of the capital investment magnitude. Higher ROI means greater value, which means a higher price can be charged — and more profit earned.

This is where economic cost is essential to understand the workings of the economy. Because if a project envisioned by an entrepreneur appears to be highly profitable, regardless of initial investment needed, she/he will pursue it. This means, at the same time, that other entrepreneurial projects, which are expected to provide a lesser return on investment, will not be pursued. What matters for society and the economy is that the greater value is pursued, because it makes all of us better off. This is why, through competition, the swift weeding out of entrepreneurs with projects that do not actually produce much value is important: they literally waste our resources because the value foregone — the projects that were not undertaken because the resources were bound up in these lesser projects — is higher than the value produced. It is an economic loss regardless of what benefits came out of it.

Consequently, we can conclude that the space program, just like war, was a wasteful act. The government stepped in because no entrepreneur was willing to undertake it, which is because its expected ROI (if any) was much lower than other projects entrepreneurs could pursue. We don't know what we lost, but it could have been cures for nasty diseases, doing away with poverty, or whatever. The fact that consumers were not expected to spend their own money on the space program, and the fact that no entrepreneurs expected that they would, at least not to the extent necessary, means it was not considered valuable enough. Its economic cost was expected to be higher than the economic value!

Now, does this mean that nothing good came out of the space program? Of course not.

There were innovations and technologies discovered that have served us well. But they were, at the time of investment, either not expected (at all) or not expected to sufficiently serve people. There are certainly examples of flukes that ended up creating beautiful things (like Arpanet becoming the Internet), but who in their right mind would argue that we should waste resources on grand government projects because there might be unintended consequences that we'd benefit from?

Considering the economic cost, what we could have gained from that investment was expected (by everyone!) to be higher than the project pursued by the government.

That's the reason the government did it. Government is in the business of wasting scarce resources at high economic cost, i.e., without sufficient expected value. No matter how one looks at it, this is wasteful. Unless, of course, one ignores the concept of economic cost: the higher-value opportunities that are foregone — lost — because we're instead pursuing the lower-valued ones.

To simplify, it is a matter of picking the low-hanging fruits first, because there is much higher return  greater "bang" for the buck — from doing so. It makes no sense climbing to the top branches "in case" there is some other and unexpected benefit from putting in the extra effort.

Formatted from Twitter, follow @PerBylund.

Per Bylund is assistant professor of entrepreneurship & Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship at Oklahoma State University. Website: PerBylund.com.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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