Decision Making: Accounting Costs vs. Economic Costs

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There ain’t no such thing as a FREE lunch”

It’s the first thing every economist learns.

And, if you are an economics nerd like me, you’ve probably annoyed your friends by using this term before too: opportunity cost (OC)

The general concept is quite intuitive. Everything has a cost, even if it is “free,” because you are paying either in dollars or time. Here is the textbook definition of OC:

Opportunity cost is the cost of the next best alternative

Let’s say your friend takes you out for lunch on a Friday, and he offers to pay. Is this lunch free? Technically, it is free in terms of gross accounting dollar $ amount. You won’t have to pay for your meal and will keep that extra $15 in your wallet. This is what economists will refer to as “accounting costs,” which is the exact dollar amounts in every transaction. Hence, accountants are great at calculating and measuring exact dollar figures.

But to an economist, just using accounting costs are not good enough. Instead, we have to factor in OC, which accounts for everything else that isn’t the dollar amount at the bottom of the statement. To an economist, you are essentially paying 1-hour to have lunch with your friend (or however long it takes you to eat lunch). And let’s say your hourly wage is $20. So, in theory, the next best alternative for you in how to spend that one hour on Friday noon is, well, you could work and earn $20. Every economist will now tell you that your OC is $20, so to have lunch with your friend, you are foregoing the opportunity to earn $20. There ain’t no such thing as a free lunch. But be careful, because there is a critical distinction between OC and AC: You aren’t paying $20 (AC), you are instead, giving up the opportunity to earn $20. Hence, opportunity cost.

Not everything you do will have an AC, but everything will have an OC. For example:

Want to watch Netflix for 5-hours on the weekends? Even if you are a student, you could work that extra 5-hour shift at the local grocery store and earn $8/hour. So go ahead, binge 5-hours of Netflix. Just know that you will be foregoing the opportunity to earn $40. Sure, your accounting costs are $0, but your true economic costs of watching Netflix for 5-hours will be $40.

Economic costs factor in both opportunity costs AND accounting costs.

So let’s say you are a confused 18-year-old and you are trying to decide whether or not to go to college for $10,000 a semester. Is it worth it? But wait, $10,000 a semester is just the accounting costs. The opportunity costs of going to university, per semester (roughly 4 months), would be 4 x 4 x 40 x 10 = $6400 (assuming you can work full-time 40-hours at $10/hour job had you decided NOT to go to college). If we think like an economist, your true economic costs of attending college per semester would be $16,400; $10,000 you pay in cash, and $6400 you’d be foregoing as opportunity costs.

This post isn’t a comprehensive analysis of how economic costs differ from accounting costs, but it’s a basic framework of how we, as individuals, can better allocate our time and energy.

When you begin to think more like an economist, you’ll realize that opportunity costs might actually be more important when factoring in decisions. Opportunity costs are deceptive because they are hidden; foregoing opportunities are difficult to measure. But nonetheless, we need to measure them, because to an economist, making rational and smart decisions means factoring in all the possible options and choosing the best one.

Ultimately, it boils down to this:

Time is valuable

So next time your friend offers to take you out for lunch, remember that nothing is free.

 

 

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