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Key Lesson #12: Cost of opportunity

Us: We have seen this topic before in Austrian Economic principles. However, it is so important that it is worth reviewing it again. Cost of opportunity (or Opportunity Cost as economists like to call it), is simply what you lose when you choose to manufacture product A over product B. Actually, it goes far beyond that, it works for any choice, which is related to an economic calculation. This obscure economic concept is actually vital to explain how the economy works. This is the principle behind the saying “There Is No Such Thing As A Free Lunch”.  Simple example: bar owner wants to attract customers. Bar owner offers a “free lunch” to anybody that spends over $100 in the bar. Bar owner loses one lunch every $100 worth or liquor. Bar owner does so because he is expecting customers to spend more than $100 per visit. Bar owner chooses to “lose” the cost of one free lunch so that he can make higher profits from $100+ sales. The “lunch” is not actually free. It is not for the bar owner and it is not for the customer. Everything has a cost, even if we don’t see it or can’t calculate it properly.

Them: The same. Yes, that’s right. The shamelessly adopted this principle from the our economists. This principle is actually so good, that any classic economic theory that does not have it, it is considered ridiculous.


Key Lesson #13: The value of instant satisfaction

Us: Humans (you, me, everybody) want things now. We hate waiting. We don’t know why this is, maybe because in order to be successful as species, every individual had to survive now. In order to do so, planning was a bad idea because too many things could change. And so we evolved as selfish people with no patience. It does not really matter. What matters is that we do want things now and in order to get them, we are willing to pay more. This is what in economics is called “Time Preference”. The more we have to wait for something, the less we are willing to pay for it.

Them: Many classic economic theories believe the same, but for slightly different reasons. And yes. They “borrowed” this concept from us too!! Keynesianism, on the other hand, has a different explanation. According to them, what people want the most is to have cash, because cash offers the lowest risk. For example, an investment that is the quickest to sell for cash, will be sold at the lowest profit. Take government bonds, the shorter the investment period, the smaller the interest paid. The idea seems to make sense. The problem is that the logic is reversed. Interest rates are higher at longer expiry dates because the market is smaller. In other words, there aren’t that many people willing to lend money for long periods of time. Therefore, they will demand higher profits; either you pay us extra profits or you can’t borrow the money. If the Keynesian logic would be true, all bond markets, at any expiry date should have roughly the same number of participants. This would be so because prices already compensate for risks. Considering bond prices, there is no risk difference between short, medium and long term expiry dates. The higher price cancels risk out. But this is not what happens. The shorter the expiry on a bond, the more people are in that market. This is so because even compensating for risk, people still want their money now.


Key Lesson #14: Capital is complicated

Us: Capital is the capacity to create production. But capital is not a statistical measure, capital is many physical and intellectual things; from know-how to money, from machinery to metals, from geographic location to market logistics. All the components necessary to manufacture something are capital. As such, they are interrelated in a very complicated way, and to make matters even more interesting, time is also involved. To create a manufacturing plant, not only those elements must come together, but they must do so in due time and this takes time. What’s the point of having the plant set-up if employees are not there? What’s the point of having employees there if one of the raw materials hasn’t arrived? And so on. These are, of course, trivial examples. But they illustrate the principle. Thus, capital can be seen as different groups of things, each one of them with unique knowledge or skills. A machine can produce many parts and a building ensures the environment does not interfere with the machine. The machine and the building are not interchangeable. They do different things. The knowledge in them is different and they take different times to be created and setup.

Them: classic economic theory assume that capital is an amorphous stock or reserve of capacity to create production. This stock is all the same and therefore it can be studied using statistics. We can study this stock by simply looking at demand and supply. Keynesians criticized this model, but they did not provide a better one; actually, they did not provide one.  Does this sound right to you? Is know-how the same as money? Is labor the same as a building?  Do they contain the same information in the same amount? Do they materialize magically at the most appropriate time where most needed? Of course not!!!

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Austrian Economics In Theory - Part 8


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