Price is Opportunity Cost

Price theory teaches you how to understand human behavior even beyond the market

Here at Economic Forces, we love to extol the value of price theory. A common preconceived notion about price theory is that it is all about understanding market activity. The word “price” seems to give that connotation. However, I would argue that price theory can be just as useful for thinking about non-market activity as it is for market activity.

I think that the reason people equate price theory with markets is the word “price.” We tend to think of prices as being tied to markets. After all, most market transactions involved posted posted or some haggling over the price.

But prices are everywhere. When I buy one thing, I give up my ability to buy something else. When I wait in line for tickets to a concert, it is tempting to think that the cost of the concert is the monetary price of the ticket. However, the monetary cost of the ticket just tells me the amount of consumption of things other than the concert that I must give up. And that isn’t the entire price of the ticket. Since I had to wait in line to get the ticket, I also gave up the time that I was in line. That is time I could have spent doing something else. If I wait in line and I buy the ticket, then clearly doing so was preferable to me than what I have given up. I have given up something nonetheless.

Prices just measure what I have to give up to get something I want. The price is the opportunity cost.

This week, I want to talk about the importance of thinking in terms of relative prices (and therefore in terms of opportunity cost). Once you do that, you can start to see how price theory can be used to think about non-market outcomes. I will provide some examples to explain why wars end and why they continue to better make this point.

It’s relative prices that matter

I think that the prices most people have in mind are often money prices. But price theory is really about relative prices. Money prices just help us make those calculations. For example, if I go to the grocery store every week, I get well acquainted with the dollar prices of many of the items in the store. If I know a lot of the dollar prices, then I also have an idea of what the relative prices are as well. For example, if I know that the price of a gallon of milk is $4 and the price of a loaf of bread is $2, then I know that for every gallon of milk that I buy means I can buy 2 fewer loaves of bread. The two loaves of bed are the cost of the gallon of milk.

Because we are familiar with money prices, we often don’t realize we are doing relative price calculations when we make decisions. Money prices aren’t that helpful though when you’re not familiar with a lot of prices. For example, with apologies to my Norwegian readers, I’m not sure whether most readers of the newsletter could tell me whether paying 20 kroner for a gallon of milk is expensive or not. This illustrates just how much we think in terms of relative prices without even realizing it.

The Alchian-Allen Theorem really illustrates this point about relative prices. Suppose that there are two couples. Each couple is planning on going out to dinner. Suppose that each couple can choose one of two possible restaurants. There is a fancy restaurant that will cost $100 and a casual restaurant that will cost $50. The first couple has small children. As a result, they will need to hire a babysitter if the couple wants to dine alone. The other couple has no children.

If you focus on money prices, you would likely conclude that the couple without children is more likely to go to the fancy restaurant since the couple with children also need to pay a babysitter. Everything is more expensive for them in terms of money prices. However, the Alchian-Allen Theorem tells us that the couple with children is more likely to go to dinner at the fancy restaurant (all else being equal) because the relative price of fancy dinner is lower for them than for the couple without children.

Why?

The couple with children pay the babysitter no matter what. Suppose the couple pay the babysitter and buy the children fast food. This costs $50. Since they pay the $50 regardless, the cost of going to the fancy restaurant for this couple is $150 and the cost of going to the casual restaurant is $100. The fancy restaurant costs 50 percent more than the casual restaurant for this couple. However, for the couple without kids, the fancy restaurant costs double what the casual restaurant does. For the couple with kids the cost of two fancy dinners is that they have to give up three casual dinners. For the couple without kids, the cost of two fancy dinners is that they have to give up four casual dinners. In other words, the fancy dinner is more expensive to the couple without children when measured in terms of casual dinners and thus they are less likely to go to the fancy dinner.

Non-market behavior and, in particular, war

Once we start thinking about relative prices and therefore opportunity costs, it becomes straightforward to think about non-market activity. Prices are still lurking in the background. Every action entails some opportunity cost, regardless of whether there is any monetary payment involved.

For example, consider the decision to steal. Theft might take planning, which requires taking time away from some other activity. Efforts to conceal a theft are also costly. Furthermore, if one is caught in the act of stealing, there is some probability of being prosecuted and suffering the corresponding punishment. By committing theft, one avoids paying the monetary cost of the theft, but one nonetheless pays a cost in terms of the planning, the efforts at concealment, and the expected punishment. When those costs go up, attempted thefts should decline.

Some things that take place outside of markets are remarkably similar to market activity. For example, Donald Wittman takes this approach to assessing how wars end. The decision to end a war typically involves some type of settlement. If the parties involved agree to a settlement, this implies that there was some type of gain to exchange. Otherwise, the fighting would continue. This is true even if one side unconditionally surrenders since this implies that the alternative is worse. Perhaps the alternative is total annihilation.

This might sound obvious. However, thinking about the end of warfare from the perspective of price theory can reveal some non-obvious conclusions. For example, state leaders will sometimes say that they are engaging in a particular offensive or bombing campaign in order to bring the other side to the bargaining table. There is some logic to this. A successful bombing campaign might reduce the expected benefits of continuing the war to the side being attacked and thus make it less costly to reach a settlement. Nonetheless, it is not at all clear that this helps bring about an end to war.

To see why, consider that the benefit of a peace settlement has an opportunity cost. That opportunity cost is that you do not get to continue the war. The higher the cost of peace, the more likely war continues.

Returning to the example, as Wittman shows in his paper, a successful bombing campaign might discourage the side being bombed from wanting to continue the war. However, for the side doing the bombing, a successful bombing campaign can potentially raise the expected benefits of continuing the war by making victory more likely. Under certain circumstances, this can make the war more likely to end. Under other circumstances, the opposite is true. If the expected benefits of continuing the war were already high or rise sufficiently high, the side that is winning might end up emboldened to continue, with less of an incentive to negotiate.

Another common misconception about war can be understood if you understand price theory. A common misconception is that when you observe a reduction in the intensity of fighting that this might be a sign that the conflict is coming to an end. I think that the focus on intensity is often conflated with a sign of weakness. However, it is important to understand that if one (or both) sides decides to reduce the intensity of conflict, it is likely that they see this as increasing the expected benefits from continuing the war. Yes, a shift toward lower intensity conflict might reduce the probability of victory. However, it also reduces the costs of warfare (and thus increases the net benefits of victory). Again, as Wittman shows, if the cost of warfare declines significantly enough, a decline in intensity could be sufficient reduce the cost of warfare and thus increase the cost of peace. A decline in intensity might therefore prolong the conflict.

Prices are opportunity costs

Much has been written about Wittman’s work and people have a lot to say about some of his conclusions. Perhaps I will return to this work in a future post. However, the broader point here isn’t about war or Wittman’s perspective.

The main point here is that price theory is all about relative prices. Given that relative prices are about comparing among alternatives, when we are thinking about relative prices, we are thinking about opportunity costs. A lot of times when we think about markets, it is easy to focus exclusively on observed prices. Often, those prices are sufficient. However, when they are not sufficient for explaining how people behave, it is often because there are other (and perhaps not-so-obvious) costs involved. Once those costs are taken into account, one is able to see the correct prediction.

Outside of markets, observable prices might be missing, but opportunity costs exist. If you can correctly identify those opportunity costs, then you should be able to use the standard lessons from price theory to help you to understand and predict human behavior.