As I mentioned in the previous post, opportunity cost, though a concept critical to economic understanding and possessing a simple enough definition ("what you give up in order to get something"), is often inadequately apprehended even by economics undergrads. Even I, after having opportunity cost beaten deep into my psyche by one of my professors in college, still fail to apply correctly the concept all too often. As I’ve engaged in further mental self-flagellation since graduation, I’ve found that the best pedagogical whip is nothing simpler than an example. If you’d like to grab your own cat o' nine tails in the interest of beating irrationality into submission, then read on (and, if learning with a buddy, remember the safety word is “laissez-faire”). Now let us consider Christmas, where sentimentality always trumps reason:
Suppose Sony has released the PlayStation 4 just at the start of the holidays, and everyone is scrambling to buy the season’s hottest new gadget. You have been dying to get your hands on one at the retail price of $300, but the PS4’s quickly sold out and the only units available are selling on eBay for over $1,000 a pop. Although a PS4 would be nice, it’s not even close to being worth $1,000 to you. It seems you’re out of luck.
Come Christmas morning, however, you are startled to see that Santa left you none other than a PS4 under the tree. Heart beating in rhythm to the cycles of a Banshee’s engine at full speed, you immediately rip open the packaging and start playing Grand Theft Auto 5, right?
Not so fast, Tommy Vercetti.
Santa wants you to be happy, right? He doesn’t care what you do with the gift he has given you; he just wants you to maximize your own satisfaction. And in order accurately to gauge satisfaction, you need to be honest about the costs and benefits of keeping the PS4.
Lucky for you, you already performed a cost/benefit calculation when you tried to purchase a PS4 before Christmas: you were perfectly willing to buy a PS4 at a price of $300, which is simply to say that at that price you deemed the benefits were greater than the cost. Just as importantly however, at a price of $1,000 you were quite confident that the cost far outweighed the benefits.
So what about now?
“Well of course the benefits are greater than the costs” you say, “for I got this PS4 for free.”
But even as this silly utterance escapes the confines of your fleshy lips, you hear a Christmas newscast reporting that PS4 units are still selling for over $1,000 on eBay. It is only then that the truth comes into sharp relief: by keeping the PS4, you are forgoing the $1,000 you that would receive if you sold it on eBay. In other words, keeping the PS4 isn’t free—it would cost you $1,000, and at that price, you recall, the cost far outweighs the benefits for you! Alas, keeping that PS4 would carry a cost you simply aren’t willing to pay. Thus, being ever the rationalist, you sell the PS4 and use the $1,000 towards more satisfying ends.
Somewhere in the distance, you hear a chortling as jolly as gumdrops: “Ho ho homo economicus!”