Saturday, January 10, 2015

The Inadequacy Of The Opportunity Cost Concept

Imagine a carpenter using a headless hammer to try and drive a nail.  After a while he stops hitting the nail with the wooden handle and scratches his head wondering what the problem is.  Would you tell him that, in order for a hammer to be effective, the handle needs a solid metal head?

For a while now I've been trying to use the opportunity cost concept to knock some economic sense into people.  Unfortunately it's not working.  Opportunity cost, as a tool, is obviously missing something essential.  But what's it missing?

Maybe it will help to have a day dream discussion with the liberal economist John Quiggin (my second favorite Crooked Timber liberal)...

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Xero:  Thanks for paying for my plane ticket to Australia...I've always wanted to visit.
Quiggin:  You're very welcome.  I've been looking forward to meeting you for a while.
Xero: Likewise!
Quiggin: Are you hungry?  I've got the barbie fired up and there's plenty of cold beer.
Xero: Awesome!  I love bbq and beer...almost as much as I love economics.  Speaking of which...how's it going with Hazlitt's sequel?
Quiggin: As you know, I've been working on this book for a really long time now.  I'd like to make sure that it's as solid as possible, which is of course why you're here!
Xero: You're writing a book based on the fact that opportunity cost is what matters...so I'm more than happy to help out any way that I can.
Quiggin:  As somebody who has extensively studied the opportunity cost concept, what faults do you see with my understanding of it?
Xero:  You argue, for example, that war has significant opportunity costs (here, here and here), which I completely agree with. Perhaps more often than not, there are much more valuable uses of society's limited resources.  The inherent problem I see with your argument is that you give no plausible method for accurately assessing the value of war compared to the value of the alternatives.  You just list some nice alternatives to war and expect your readers to assume that any of these alternatives would have created more value for society.
Quiggin: And your solution would be to allow taxpayers to choose where their taxes go?
Xero:  Yes, if our theory is correct that war really isn't the most valuable use of society's limited resources, then most members of society will not be willing to sacrifice the alternative uses of their own tax dollars.
Quiggin:  Isn't there another way to accurately asses the value of the alternatives?
Xero:  The mainstream method has been to simply assume omniscience on the part of government leaders.  But if you maintain this absurd assumption, then you really can't ever question whether war is truly the most valuable use of society's limited resources.  Given that you do question the allocation decisions of government leaders, it means that you've dropped this absurd assumption...but you haven't shared which valuation system you've replaced it with.

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Let's break it down...

1. War uses limited resources that could have been put to different uses
2. Some of those different uses might have created more value for society
3. It's important for resources to create more, rather than less, value for society

I'm pretty sure that Quiggin would agree with these three points.  What does he do with them though?  What are his options as a liberal?  Pretty much his only option is to argue that liberal leaders, in comparison to conservative leaders, would put society's limited resources to more valuable uses.  As if, somehow, liberal leaders are more omniscient than conservative leaders.  I'll believe this when I see their "titles"...
Apparently, then, the legislators and the organizers have received from Heaven an intelligence and virtue that place them beyond and above mankind; if so, let them show their titles to this superiority. -  Frédéric Bastiat
Quiggin clearly grasps the opportunity cost concept...he's even writing a book about it.  Yet, despite this, he still clings to the omniscience assumption.  And unfortunately, he's the rule rather than the exception...
I wonder how much progress could be made in political economy if the best and the brightest among economists, such as Raj Chetty, would take seriously the admonition of Hayek, Buchanan, and Elinor Ostrom that the assumptions of omniscience and benovolence must be rejected if we are going to make progress and develop a robust theory of political economy. - Peter Boettke, AEA Richard T. Ely Lecture --- Raj Chetty, "Behavioral Economics and Public Policy"
So what's opportunity cost missing?  It's missing the part that smashes the omniscience assumption.

Perhaps the concept that comes closest to smashing the omniscience assumption is "individual valuation".  I discussed this at length in my previous blog entry... What Would Tyler Cowen Do For A Klondike Bar?

"Individual valuation" should convey the idea of millions and millions of taxpayers...

1. weighing the alternative uses of their own tax dollars
2. choosing the most valuable uses

Maybe "individual valuation" could be trained to do this...but I don't know if this is what it currently does.  Perhaps upon seeing this term, some genius reader would automatically think of a King, an individual, deciding that a war was worth the opportunity cost.  This undesirable interpretation really wouldn't smash the omniscience assumption.

Maybe "crowd valuation" would do the trick?  Again, it's entirely possible that it could be trained to do the trick but without this training I wouldn't be surprised if the genius reader would automatically think of participatory budgeting (PB).  Well...at least PB does call the omniscience assumption into question.  

What about "earner valuation"?  Neither kings, nor congress, actually earned the money that they've been able to spend.  So unlike opportunity cost, earner valuation isn't applicable to kings/congress deciding between wars or welfare.  Earner valuation would be applicable to taxpayers, the people who personally sacrificed in order to earn the money, weighing the alternative uses of their own tax dollars.  Yes..."sacrifice"...
As he likes painting, Dad becomes a painter.  He works hard so we want for nothing.  So we want for nothing...but the presence of my father who works hard so we want for nothing. The Names of Love
Maybe "earner valuation" could really smash the omniscience assumption.

But pretty much any term, whether old or new, could be trained to smash the omniscience assumption.  Really it's just a matter of enough free market types agreeing that our conceptual tools have quite a bit of room for improvement.

So let's take a look at some more evidence regarding the inadequacy of the opportunity cost concept.  From the preeminent liberal economist Paul Krugman...
Well, if there’s one thing I thought economists were trained to do, it was to be clear about opportunity cost. We should compare accumulation of dynastic wealth with some alternative use of resources – not assume, as Mankiw in effect does, that if not passed on to heirs that wealth would simply disappear. Maybe he’s assuming that the alternative would be riotous living by the current rich, but that’s not a policy alternative. 
In fact, what we’re really talking about here is taxation of wealth., and the question is what would happen to that revenue versus what happens if the rich get to keep the money. If the government uses the extra revenue to reduce deficits, then all of it is saved – as opposed to only part of it if it’s passed on to heirs. If the government uses the revenue to pay for social insurance and/or public goods, that’s likely to provide a lot more benefit to workers than the trickle-down from increased capital. 
The point is that you can only justify Mankiw’s claim that inherited wealth is necessarily good for workers by insisting that the government would do nothing useful with the revenue from inheritance taxes. I’d call that assuming your conclusions; in any case, it’s a claim that deserves to be made openly, not smuggled in on the pretense that you’re just doing economic analysis. - Paul Krugman, Sympathy for the Trustafarians
If economists are trained to be clear about opportunity cost, but the omniscience assumption prevails, then this strongly supports my conclusion regarding the inadequacy of the opportunity cost concept.  Here we see Krugman using opportunity cost correctly...but he's also implicitly relying on the omniscience assumption to derive the value of the alternatives.  Well...in any case, he's definitely not relying on earner valuation to derive the value of the alternatives.  And anything other than earner valuation is the economic equivalent of voodoo.  Actually, at least there's some demand for voodoo.  I'm pretty sure that there's absolutely no demand for impersonal shoppers.

More evidence, this time from my favorite liberal politician...
According to the S&P index, the government shutdown had delivered a powerful blow to the U.S. economy. By their estimates, $24 billion has been flushed down the drain for a completely unnecessary political stunt.

$24 billion dollars. How many children could have been back in Head Start classes? How many seniors could have had a hot lunch through Meals on Wheels? How many scientists could have gotten their research funded? How many bridges could have been repaired and trains upgraded? - Elizabeth Warren, Dysfunction
Warren grasps the opportunity cost concept.  But does she have any desire to smash the omniscience assumption?  Not a chance.  She is the omniscience assumption.

Yes, $24 billion dollars could have put many children back into Head Start classes.  But how much value would this have created for society?

Warren's omniscience answer?  ________
Earner valuation answer?  ________

Yes, $24 billion dollars could have provided many seniors with hot lunches through Meals on Wheels.  But how much value would this have created for society?

Warren's omniscience answer?  ________
Earner valuation answer?  ________

Yes, $24 billion dollars could have provided many scientists with funding for their research.  But how much value would this have created for society?

Warren's omniscience answer?  ________
Earner valuation answer?  ________

Yes, $24 billion dollars could have repaired many bridges and upgraded many trains.  But how much value would this have created for society?

Warren's omniscience answer?  ________
Earner valuation answer?  ________

Speaking of science funding...here's a West Wing (TV show) dialogue between a liberal White House staffer, Toby, and a conservative congresswomen, Layton.  You can watch their opportunity cost discussion on youtube...and read the entire transcript here... Eppur Si Muove

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Layton:  Nobody wants to blow up the NIH here. I promise I won't even mention the Supercollider.
Toby:  No, you guys pretty much took care of that one already.
Layton:  I hope you will convey my deepest sympathy that the President's daughter has been dragged into all of this.
Toby:  I'll do that. He'll be delighted to hear that we won't be seeing anything about Ellie Bartlet in your fundraising materials.
Layton:  It wasn't my decision for her to go work in a lab doing questionable research on Uncle Sam's dime.
Toby:  And you decide what's questionable?
Layton:  It's my job. I'm on the authorizing committee for that money. There's nothing wrong with healthy scrutiny.
Toby:  Healthy scrutiny, not subjective attack. Your list isn't about priorities. It's about imposing ideology and religious doctrine on the awarding of individual scientific grants.
Layton:  It's the taxpayers' money.
Toby:  Your disapproval of high-risk behaviour is justification for stifling the research to reduce it?
Layton:  I don't have a problem with homosexuals, or injection-drug users. But there is only one pie, and we're talking about using $2 billion dollars of it on the small percentage of the population with HIV, which will mean cutting funding on Alzheimer's, muscular dystrophy, and diabetes, multiple sclerosis.
Toby:  Oh, good. The MS card. This doesn't have to be one or the other.
Layton:  One in eight women will get breast cancer and at least 15% of those aren't going to live five years after the diagnosis. Every dollar you spend on studies of Puerto Rican sex workers is one that you take away from cancer centers and clinical tests.
Toby:  You don't know that. You don't know where undirected research will lead. You're not a scientist and neither are the members of the Traditional Values Alliance. What are you doing in bed with these people?

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Layton has a solid enough grasp on the opportunity cost concept but she gives no plausible method for accurately ascertaining the actual amount of value that the alternatives would create for society.  This indicates that she does not grasp the earner valuation concept.

Evidence in terms of healthcare funding...
Thomas Carlyle famously called economics "the dismal science". I saw this in action when on a panel, interviewing health economists. We decided to ask all candidates an amusing "unexpected" question at the end: "Which concept from economics should be better known by the general public?" 
Any economist reading this will already know how they all answered: "opportunity cost". In judging whether it is right to spend money in a particular way, you should first think what else you could be doing with it. Could you squeeze out a little more value or enjoyment? Health economics is dominated by considerations of opportunity cost. When the government created a new fund for cancer treatments, for example, economists immediately asked what we would have to give up to pay for it. - Jonathan Wolff, How to measure if a degree is worth the debt
Economists ask what "we" would have to give up to pay for cancer treatment...and then voila!?  The actual valuation of what's sacrificed is known?

To be fair, it's really important to help people understand that even with an unlimited budget...any resources allocated to cancer treatment can't also be allocated to other uses.  It's a fundamental economic truism that any allocation will always sacrifice alternative allocations.  But this is just the tip of the iceberg.

The large bulk of significance is found in accurately assessing the value of the alternatives.  And given that values are subjective and circumstances are unique and constantly changing...correct (accurate) answers can only be supplied by each and every member of society deciding for themselves what they are personally willing to sacrifice.  Markets work because valuation is extremely inclusive.  Governments fail because valuation is extremely exclusive.

The evidence is pretty clear that the opportunity cost concept is woefully inadequate.  We need it to do a much bigger job than the job that so many economists have assigned to it.  While no term's meaning is set in stone...it would take a lot of effort to try and expand the scope of the opportunity cost concept.  So perhaps it's easier to simply come up with a new term...like "earner valuation" or some better term.

At the beginning of this post, I mentioned that I've tried to use the opportunity cost concept to knock some economic sense into people.  But now that I've come face to face with the fact that this concept really isn't the concept that it should be...I should say "mea culpa" to all the victims of my misattribution.  There are two victims in particular that I should apologize to...Noah Smith and Matt Zwolinski.

If you search Smith's blog for "opportunity cost" you can find several instances where I hit him over the head with opportunity cost.  For a good example with Zwolinski check out this blog entry... Fallibilism vs Fairness.  Sorry guys...I should have been smacking your heads with an economic term that hadn't been invented yet.

Ok, let's review.  I want to make sure that I'm not imagining a gap in the economic tool belt.

When kings or congresspeople spend a portion of their country's income on war...there's an opportunity cost.  The opportunity cost is the amount of value that would have been created with the resources if they hadn't been used for war.

If a liberal, such as John Quiggin, argues that the opportunity cost of war is too high, he's saying that the alternative uses of the resources would have created more value.  More value for who though?

1. For himself?
2. For the kings/congresspeople?
3. For society as a whole?

I'm going to go out on a limb here and guess that the correct answer is #3.  So basically he's making this argument...

1. War creates x amount of value for society
2. The alternatives would have created y amount of value for society
3. x < y

What's implied here is that it's better for society's limited resources to create more, rather than less, value for society.  I get the feeling that we should call this something.  Doesn't it seem important enough to deserve a name?  How about "Quiggin's Implied Rule of Economics"?  Heh.  Maybe 1000 years from now they'll complain that I didn't put enough thought into the name.  Well...sorry future people for not having enough thoughts for you.

Quiggin leaves us hanging though.  He gives absolutely no clue how he's deriving x or y.

If he uses the currently accepted method, then x and y are determined by omniscient government leaders.  But if he chooses this method, then his concern, regarding the opportunity cost of war, would have him questioning all-knowing beings...which is a fool's errand for sure.  All-knowing beings work in mysterious ways.  Hence, the need for faith...which Quiggin is clearly lacking.

While we don't exactly know which method he is using to derive x or y...we do know for sure which method he isn't using.  He definitely isn't using the earner valuation method.

With the earner valuation method...each and every taxpayer would decide for themselves whether a war was worth sacrificing all the other public goods that they could spend their own tax dollars on.  Their allocation decisions would reveal the amount of value that society derives from the various tax allocation options.

Without earner valuation, in terms of public spending...every opportunity cost story is either extremely flimsy or full of fantasy.  When Quiggin says that the opportunity cost of war is too high...he's basically saying that society would derive more value from other things besides war.  He masterfully builds the suspense...and then...and then...nothing.  The story ends.  That was the end of the story?  But how in the world did he know how much value society actually derives from any public good?  Maybe in the sequel to Hazlitt's sequel we'll learn that Quiggin is omniscient and he's going to run for congress...or whatever it is that they have Down Under.  People would read it and say "Ahhhh...HA!  So that's how he derived society's valuations!  I knew it!!!"  If you wanted to find this sequel to Hazlitt's sequel then you'd definitely have to look in the fantasy section.

Out of curiosity I searched Crooked Timber for "Hazlitt" and found this blog entry that he posted last July... Hazlitt, Keynes and the glazier’s fallacy.  Reading this...
But governments can do much better than this. First, they can spend money on things that are more useful than breaking windows and repairing them (or, in Keynes’ presentation of the same argument, burying bottles full of money in coal mines and letting people dig them up). They can give money directly to individuals and families through benefits or tax reductions. Alternatively, they can create jobs by undertaking public works or by expanding public services. 
Second, they can target their efforts towards groups who are likely to spend any additional income (in the economics jargon, they have a high marginal propensity to consume), most obviously low-income families.
...you really get the sense that he's forgetting Quiggin's Implied Rule of Economics.  How could he forget his own rule?  For goodness sake, I named it after him just so he wouldn't forget.  Here it is again...

Quiggin's Implied Rule of Economics: it's better for society's limited resources to create more, rather than less, value for society

Between Quiggin, Krugman, Warren and Noah Smith...we can compile a list of a gazillion really good things that they want the government to do with society's limited resources.  But if we agree that Quiggin's Implied Rule of Economics is worth adhering to...then how, in the absence of earner valuation, can there be any guarantee that this wonderful rule will not be violated?  How can these liberals ensure that their perfect government will create the most value with society's limited resources?

The fact of the matter is that relying on omniscience, or anything other than society's actual valuations, guarantees that Quiggin's Implied Rule of Economics will be regularly violated.  So it's the ultimate irony when Quiggin uses the logical consequences of his rule being violated...unemployment and recessions...as justifications for feeding, promoting and encouraging the very system that's directly responsible for violating his rule and producing these negative consequences.

Quiggin's Rule is a good rule because there are beneficial consequences when it's followed and harmful consequences when it's violated.  In order to ensure that this rule is followed, rather than violated, the government must replace its system of exclusive valuation with the market's system of inclusive valuation.  It's absolutely imperative that we, the people, be given the opportunity to decide whether what we want is truly worth our own personal sacrifice...
The people feeling, during the continuance of the war, the complete burden of it, would soon grow weary of it, and government, in order to humour them, would not be under the necessity of carrying it on longer than it was necessary to do so. The foresight of the heavy and unavoidable burdens of war would hinder the people from wantonly calling for it when there was no real or solid interest to fight for. The seasons during which the ability of private people to accumulate was somewhat impaired would occur more rarely, and be of shorter continuance. Those, on the contrary, during which the ability was in the highest vigour would be of much longer duration than they can well be under the system of funding. - Adam Smith, Wealth of Nations
How many wars would have been avoided if the people wantonly calling for them (voting = cheap talk surveys) had no choice but to feel the complete burden of their war wishes?   If the opportunity cost of war is truly a concern for John Quiggin, then he really doesn't have to look any further than Adam Smith for the solution.  The solution is as simple as giving people the opportunity to put their own tax dollars where their mouths are.  

Not only would taxpayers' deep input ensure that we avoid unnecessary wars, but it would also ensure that we avoided employing people to do things that nobody in their right mind would pay them to do...
This means that the terraces of the Champ-de-Mars are ordered first to be built up and then to be torn down. The great Napoleon, it is said, thought he was doing philanthropic work when he had ditches dug and then filled in. He also said: "What difference does the result make? All we need is to see wealth spread among the laboring classes." - Frédéric Bastiat, What Is Seen and What Is Not Seen
Quiggin wants the government to employ people...which is really wonderful.  But if the government is going to employ people...then according to Quiggin's own rule...it should employ them to create more, rather than less, value for society.  In other words, it should employ them to help meet society's demand for public goods.  We can make sure that this happens by giving Quiggin the freedom to directly allocate his taxes.  If he can choose to spend his own taxes on employing people to supply 1. something less valuable or 2. something more valuable... then I'm pretty sure that he's going to choose the second option.  All taxpayers would do the same and this would ensure that the maximum amount of value was created for society as a whole.

So what's the opportunity cost concept missing?  At least in terms of public spending, the opportunity cost concept is missing Quiggin himself.  It's also missing you, me and nearly everyone we know.  Nothing can be correctly valuated without us.  We are what's needed to smash the omniscience assumption.  There really should be an economic term that conveys the idea that we, the people, are exactly what public spending is missing.  "Earner valuation" (15 search results) might do the job...but there's always room for improvement.












































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Bueller's Basement

Now it's time for the awkward moment when the blog entry ended a long time ago but you and I are both still here.  This time you might really regret lingering for so long.

The ending of this blog entry reminded me of the wonderfully weird and incredibly awkward indie movie... Me and You and Everyone We Know... which of course made me think of this... ))<>((.  Don't click on either link if you haven't watched the movie but plan on doing so.  Not only is the last scene in that youtube video awkward, inappropriate, hilarious and poignant...it was also was really nicely shot.  The value to space ratio of that scene was extremely high.

Speaking of romance...not sure why I feel inclined to publicly admit this...but I have a crush on Elizabeth Warren.  Fifteen minutes on the couch with her, what a good idea.

Possum Dixon bordered on profound perfection.

Contemplating my couch time with Elizabeth Warren reminded me of another wonderful movie...The Names of Love.  An attractive liberal woman goes around seducing conservative guys into becoming liberals.  It just inspired me to add a quote from the movie to this entry.

Anything else?  Oh yeah, those pesky future people.  Hey people a 1000 years from now...why do you obligate me so?  Are you really going to read this and accuse me of doing too little to make your world a better place?

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