Child’s Guide To True Cost Of Activities: Concept Of Opportunity Cost
By W A Wijewardena –
Aseni, whiz kid in economics, and her grandpa, Sarath Mahatthaya, are in discussion on how money cost can deviate from the true cost of an activity and its implications on the personal as well as the country economic life. The issue has received their focus because of the long queues for essential items, especially for fuel, milk food, and cooking gas, in Sri Lanka where people pay a low money cost but spend hugely in terms of the sacrifice of their real resources.
The following is the conversation;
Aseni: Grandpa, standing in long queues for days and days to get fuel, cooking gas, and milk food has become a daily occurrence in Sri Lanka. Pretty soon, this will be extended to other essential goods like rice too. This is because the Census and Statistics Department, in releasing the GDP numbers for the first quarter of 2022, has noted that the ban of chemical fertilisers has caused the agriculture sector, especially the cultivation of paddy, to fall by about 7%. This refers to the Maha season of 2021/22 and in the Yala season of 2022 too, there has been a low extent of paddy lands cultivated by farmers due to the same problem. We may run into a rice deficit in the months to come. What are the economic implications of these long queues?
Sarath: When we buy a good or a service from the market, we make a sacrifice, and that sacrifice is denominated in money terms as its agreed price tag. For instance, when we buy a litre of petrol for Rs. 550, our money sacrifice is Rs. 550. However, to earn that money, we should make a real sacrifice. Suppose we must work for one hour to make that amount of money. If so, one litre of petrol is equal to one hour of our work-life. If petrol is available at the pumping station and we can get it without making a fuss, then, money cost that we incur is equal to its true cost. This exchange is called a transaction and it is not over until the whole transaction is complete. But to complete the transaction, we may have to make additional sacrifices other than what we pay to the pumping station owner.
These additional sacrifices can take different forms. One is that we may have to stand in a queue to get this one litre of petrol. Another is that we may have to pay a bribe to the pumping station owner or to an employee or to a connected party. A third is that when we stand in the queue, we may meet with an accident. A fourth is that we may be beaten by police or by another person standing in the queue or by a total stranger. A fifth is that if we are arrested by the Police for whatever the reason, we may have to incur legal costs to get ourselves freed from jail. A sixth is that we may fall sick in the queue and incur medical expenses.
These are all real sacrifices we make to get this one litre of petrol. But if they are there, the true cost that we incur to get this one litre of petrol is higher than the money cost that we incur. In that case, the actual sacrifice is not one hour of our work-life but many more work-hours. These real sacrifices should be considered when we calculate the true cost of our acquiring a good or a service from the market.
Consider, for example, that the additional sacrifices that we must make are equal to five hours of our work-life. If one hour is equal to Rs. 550, the total additional sacrifice is equal to Rs. 2,750. When we add the money cost to this, the total cost amounts to Rs. 3,300. So, we buy a litre of petrol not for Rs. 550, but for Rs. 3,300.
The existence of these transaction costs makes the distribution of goods and services inefficient because it requires people to make more sacrifices than what they get. If the system is inefficient, it leads to waste of scarce resources. No country has a plenty of resources to waste like that. That inefficient production system makes that country poorer by the day. This is something that we must avoid if we want to progress.
Aseni: I understand that when there are positive transaction costs, there are people who lose these extra resources. But isn’t there anyone who gains out of this?
Sarath: These sacrifices can be broken into two categories. In the case of one category, the person involved makes a sacrifice, but there is no one who gains out of that. These types of sacrifices are called ‘deadweight losses’. For instance, if a person stands in a queue, he loses because he foregoes all the other income making opportunities. They are called opportunity costs. Similarly, if the person is beaten or arrested by the Police, he loses but no one gains. That is also a deadweight loss. Similarly, if he gets injured or as an extreme case, dies, while standing in the queue, he loses but no one gains. These are net losses to the economic system. It is the duty of the economic policymakers to design measures to eliminate, and if it is not possible, to minimise these deadweight losses.
In contrast to these deadweight losses, there are certain transaction costs which are gained by someone in the system. For instance, if the person involved has to pay a bribe to someone to get the right to have the good, the bribe taker gains. Similarly, when one stands in the queue, say to get petrol for his vehicle, a petty thief may steal some valuable part of the vehicle like the side mirror or a sticker, the vehicle owner loses but it is gained by the thief. But these types of gains which some people make do not contribute to the welfare or the prosperity of society. Hence, they are unproductive gains.
When there is the possibility for making such unproductive gains, people will try to grab those opportunities because they are easy ways of making money. With this positive incentive, when all the people try to become thieves or practitioners of immoral acts, society cannot progress because it cannot become richer by stealing from itself. Like the deadweight losses, it is the duty of the government to eliminate or keep at a minimum the possibility for making these unproductive gains.
Aseni: I now understand, Grandpa. In the current fuel crisis in Sri Lanka, there are stories that if you pay some Rs. 1,000 to the filling station pump operator, you can get the full tank of fuel. So, that is a bribe, and he gains, while the car owner loses. But the payment is an unproductive payment because the Petroleum Corporation could have earned that Rs. 1,000 if it had increased the price. What this means is that if there is a shortage and if prices have not been allowed to go up, it involves deadweight losses, on the one hand, and opportunities for earning unproductive incomes by some, on the other. With these losses around, the actual sacrifice by fuel users is much more than the money cost they incur. In real terms, they sacrifice much more than what they pay in money terms. I recall our economics teacher telling us that what should be considered in these cases in only opportunity cost. But you have broadened it and developed the concept of transaction cost that includes many other things as well. Am I correct, Grandpa?
Sarath: Both your teacher and you are correct about the importance of the opportunity costs. In fact, it is one of the fundamental key principles in economics. If you do not know it, we can say that you do not know economics. Therefore, good teachers in economics teach opportunity cost to their students before they teach anything else. What did your teacher teach you about it?
Aseni: She told us that the basic issue in all our economies is the relative scarcity of the things which we have. For example, she told us that she had Rs. 5,000 in her purse, but it was not sufficient for her to buy everything that she wants to buy. Therefore, she has to make a choice. That choice was to select this thing against that thing. Both are alternatives and, hence, it is a choice among alternatives. For example, she said that she wanted to buy a saree as well as a handbag. But if she bought the saree, she had to forego the handbag. Hence, the foregone opportunity of the saree is the handbag. Hence, the handbag is the opportunity cost of buying the saree. She said that if that cost is more than the value of the saree, then, she had made an inefficient choice. Hence, one should always look at the opportunity cost of what one does and make the best choice for oneself. This was what we were taught. Is it wrong, Grandpa?
Sarath: No, your teacher is perfectly correct, and she had well-explained the concept of opportunity cost. The whole problem about our choice making is that we go for choices where the opportunity cost is bigger than the choice that we make.
You will now realise that in our broader concept of transactions costs, opportunity cost is also one element. When the person stands in the queue to buy petrol, he foregoes the income that he could have earned during that period. We have seen people standing in queues for days and days to buy petrol. They waste their productive hours in the queues. That loss in income should be added to the transaction costs to decide on the true cost of the petrol they buy. While the opportunity cost is always there, it is high in the case of high-income people and low in the case of low-income people. But everybody makes that sacrifice. But if someone is unemployed or does not do any productive work, the foregone opportunity of standing in a queue is zero. Therefore, when he gets petrol for Rs. 550 per litre is a real gain for him.
Aseni: Does this mean that if there are unemployed people in the country, there is nothing wrong in getting them to stand in a queue and get what they want?
Sarath: No. Even though they are presently unemployed, they can be productively used for some other engagement. Hence, society, as a whole, loses. That is because we could have distributed those goods through the market system without getting those people to stand in a queue. There was a good example which had been provided some time back to explain this. The government had recruited unemployed graduates to public service and used them to distribute the seeds for home-gardening. True that they distributed those seeds. But those seeds could have been distributed through the market system too. In that case, there is no cost involved. And those graduates could have been used to provide some productive service to people in other areas of government services. Therefore, it was an inefficient engagement.
Normally unemployed people love to stand in a queue to get a good. That is because they stand to gain once the good is issued to them. But they forget that there are other costs they incur like the ones we have included in the transaction costs. There, they make an additional real sacrifice which even in their case is very costly. That is why I broadened it as transactions cost and not merely the opportunity cost.
Aseni: How does this inefficient distribution affect the overall economy, Grandpa?
Sarath: We lose total production in two ways, one directly and the other indirectly. Directly, when we get productive people to stand in the queue instead of working in factories, fields, or offices, there is a loss of output. It reduces the total output of society and makes it poorer. Indirectly, when these people incur high transaction costs, if they use those goods they get as inputs for production, the true cost of those inputs will be much higher than their money costs. For instance, suppose a farmer stands in a queue risking being injured or beaten by the Police to buy diesel to operate one of his agricultural implements, his costs go up making his operation unprofitable. It is not directly reflected in his profit and loss account, but it is personally felt by him. This indirect increase in costs makes economic activities inefficient. When we have a society-wide inefficiency, it is a real impediment to prosper and create wealth for people. Those societies do not progress at all.
Aseni: The Government has introduced a token system to distribute fuel. Does it not eliminate the transaction costs?
Sarath: No. That is because even if you get a token, you will still have to stand in a queue to buy fuel. Those in the medical profession are issued with tokens. But they have to stand in a queue for hours to get the rationed fuel for their vehicles. So, there are now two types of queues. One to get the token and the other to get fuel. So, the transaction cost is doubled instead of being eliminated. Besides, there are two other costs too. One is that Army and Police personnel have to spend their time to distribute tokens and check them when people turn up at filling stations to buy fuel. That is a deadweight loss. The other is that you can sell your token to someone else and make some unearned money which in economics we call ‘rents’. We are offering rent-seeking opportunities to people and the existence of rent-seeking in society is a sign of inefficiency in the economic system.
This transaction cost can be minimised if the issue of tokens and the notification of the availability of fuel is digitalised. You can log into an app, get registered with details, and get a digital token. With the contact number given, they could be notified of the availability of fuel, when and where. Then, they need not stand in a queue and incur high transaction costs. When things can be easily managed in this digital age, there is no necessity for the government to get people to stand in queues for days.
Aseni: Wow! I have learned a lot today. What we should be concerned about is not the money cost that we incur but the true cost that includes the transaction costs as well. The existence of high transaction costs reduces the welfare of people at a personal level and of society at an aggregate level. Hence, proper economic planning requires governments to eliminate these transaction costs if they are concerned about the long-term economic growth of the respective countries.
Sarath: Yes, indeed.
*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com
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