Imagine the following situations:
1) A young man enrolls in a tuition-free public university. From his point of view he gets the education for free. He will study in a field of his choice for five years, and after that he will be granted master’s degree.
2) A freelancing website developer decides to renovate his flat on his own instead of hiring a renovation team for 1,000 dollars. He will spend two weeks doing it.
3) A good and respected baker leaves his job and sets up his own bakery. This will allow him to earn 24,000 dollars in the first year of his business.
4) Just after New Year’s Eve a man buys slightly discounted fireworks for 1,000 dollars. He stores them in his home, and sells them after a year for 1,030 dollars.
On the surface it seems that each of these people have made a profit. The student acquired education for free, the freelancer saved a thousand dollars, the baker earned 24,000 dollars, and the last man sold fireworks with a 3% profit. But let us look at this from another perspective.
1) The student chose a stagnant field of studies. Employers will not need his knowledge after his graduation, so he will probably have to apply for a job without any higher education requirements. Instead of going to a university, he could have applied right away for a job paying him 20,000 dollars a year, or 100,000 dollars in the five years. What’s more, he would have gained professional experience that would quickly allow him to apply for a promotion.
2) By deciding to repair his flat himself, the freelancer forgoes a website development job for a large company. If he had accepted the job, he would finish it in two weeks and earn 3,000 dollars. By devoting his time to renovate his flat, he deprived himself of the opportunity to earn the money. If he had chosen instead to hire a renovating team and to take the commission, he would end up with 2,000 dollars still in his pocket despite having to hire the team for 1,000 dollars.
3) The baker who started his own business previously worked for a large network of bakeries. There he earned 3,000 dollars a month, which amounts to 36,000 dollars a year. By working on his own he could earn only 24,000 dollars a year, so by choosing to start a business he lost an opportunity to earn an additional amount of 12,000 dollars a year. Moreover, he forgoes the safety of a full time job and took upon himself the risk of running a business, that is, on the one hand, the risk of losing the money he invested in it, and, on the other, the additional stress.
4) The man selling fireworks earned 3% profit of 1,000 dollars. Instead of buying fireworks, he could have deposited his money in a savings account with 5% of annual interest, which would net him 50 dollars in a year. He also lost his own time and storage space in his home.
Thus enters the notion of the opportunity cost, meaning the cost of forgone opportunities. Economists define the concept in several ways:
“The second-best option for an action given a present choice” – Mateusz Machaj, PhD
“The subjective value placed on the next-best alternative that must be sacrificed because of a choice” – Robert Murphy, PhD
“Opportunity cost is a subjective idea. Only the individual chooser can estimate the expected value of the best alternative. In fact, we seldom know the actual value of the forgone alternative, because by definition that opportunity lost is ‘the road not taken’ – the alternative passed up in favor of the preferred option” – William A. McEachern, PhD
Every human decision incurs costs. This is due to the fact that people cannot act in two divergent ways at the same time, so they must choose between actions. In the end, they have only one body with two hands, and cannot be in two places at the same time. Moreover, the resources people use are limited or scarce. People must constantly decide whether the value of the chosen option exceeds the value of the rejected option, that is the cost.
In the above examples, each of the described people gained money in accounting terms. However, in economic terms each of them suffered a financial loss. If the only motivation for people were money, we would say that each one of them lost. Such an assumption would be wrong, however, because people are not driven solely by money. We call the other, non-monetary subjective gains from action the psychic profit. This is explained very clearly by Professor Machaj in the “Free Entrepreneurship” textbook:
“All people that act seek profit. It is not merely about making money, or strictly speaking assuring that their monetary income outweighs their monetary costs. What counts is another gain: the psychic profit. … [P]eople can be driven by vastly different ends, and seeking material wealth is but one of them. They may also seek personal happiness, aesthetic sensations, or fulfillment in religious beliefs. All in all, such are the ends people usually strive for in their actions. This is why the monetary (or purely material) gain is often just a means to another end, such as the use of one’s free time to one’s satisfaction (understood subjectively and individually).” Let us go back to our examples once again.
1) The student is aware that his field of studies will not help him find a well-paid job, and that he could have looked for a job without the delay. But for him his great passion for the field outweighs this. Although he will not use the knowledge he gained during his studies to gain money, he will make an extensive use of it during his free time, and this will enrich his life experience in many pleasant moments.
2) The freelancer loves physical work at home. He revels in the deep satisfaction that doing something by himself gives him. He also likes the thought that he will be able to tell his friends that will visit him, that he carried out the whole renovation on his own. He expects their praise to positively affect his well-being.
3) The baker very much disliked his previous job. He became frustrated with his bosses, who were ignoring many of his ideas for new products. He also disliked taking orders. By establishing his own bakery, he gained the independence he craved for. It is worth noting that if the baker succeeds in developing his business, he can make a monetary profit as well. Given a year or two, he may start to earn, say, twice as much as he did in his previous full time job.
4) The man who has invested in fireworks dislikes and distrusts banks. He got into his head that should he deposit his money in a savings account, he would never get it back. If he chose to deposit the money, he would worry all the time about it. So to spare himself the stress he chose instead to invest in fireworks and have his peace of mind.
Our characters may subjectively judge the combined monetary and psychic profit to be greater than the opportunity cost. People vastly differ. They enjoy very different things, and can value the things they forgo differently. Only one who makes the choice knows whether one has gained or lost in the process. There is no way to judge this objectively, or outside of the mind of the person making the decision. Certain things, however, we know for sure. We know that at the moment of putting the choice into action the human being subjectively values the chosen option more than the opportunity cost. After the fact it may turn out that the reality differed from one’s expectations. In such a situation one may regret the action as a subjective loss. We also know for sure that every action has a cost. When a man chooses to visit a particular restaurant, he forgos being in another one at the time. When a company invests in financial instruments, it forgos buying new equipment for its factory floor. When the government builds a road, the capital pushed away from the private sector cannot be productively used somewhere else. According to the timeless advice of Frédéric Bastiat, it is thus beneficial to look not only at that which is seen, but also at that which is not seen.
We wish to express our gratitude to Stanisław Kwiatkowski, an economist at the Ludwig von Mises Institute of Economic Education, who helped in scientific editing of the script to this video. For more videos and other materials, please visit econclips.com. If you liked our video, please share it with your friends.
