Accounting for Prudent Choice
2. Prudent choices

Choice is everywhere. You could eat cereal instead of a muffin, wear the blue sweater instead of the gray sweatshirt, ride a bike to class instead of taking the bus, eat in the cafeteria instead of at a restaurant, drink one cup of coffee instead of two, get a pizza for dinner instead of going to the dining hall.

But why? Social scientists have many ways of thinking about human motivation and behavior. A psychologist might focus on the individual's sped-up reaction time after drinking two cups of coffee, or on her use of coffee to achieve a sense of well-being. A psychoanalyst might dig into her subconscious motivations for drinking coffee. A marketing consultant might collect statistics on how advertising changes her consumption habits. A sociologist might look at social class, group pressure, and social roles to determine how society influences one's behavior.

Economists focus on the self-perceived costs and benefits of people's actions. They assume that people pay attention, and try to choose what they themselves regard as the most advantageous course of action. In short, economists assume that people make "prudent" or "rational" choices.

Prudence or rationality means making what one believes to be the best choice under the circumstances.

In more formal terms, a prudent choice is one that maximizes the decision makers' expected net gain, defined as

expected net gain =
expected benefits from the action — expected costs of the action

This is not rocket science. It's just common sense. "Look for the best deal." "Do what you think is best." "Take actions that yield benefits in excess of cost."

But it's important to understand what is not assumed by this economic concept of prudent behavior.

  • Economists do not assume that individuals are selfish.

    Economists assume that people are purposeful and prudent. The purposes, the ends, could be selfish---die with the most money in the bank. But they could also be generous or noble. A person has ends, goals, loves, priorities, projects, dreams, things that are important to her. If she's "prudent" by an economic definition she uses the means to achieve the goals wisely. They do not assume that people are selfish in the narrow sense of "greedy" or "lacking consideration for others" or "worse than Shallow Hal." In the economic way of thinking, Warren Buffet did not gain or lose rationality when he announced on a day in June, 2006 that he would give 85% of his Berkshire Hathaway fortune, valued at more than $40 billion (that's forty thousand million, class), to the Bill Gates Foundation and four other philanthropic foundations. He simply made another prudent choice that day, given his desires and resource constraints. So did he when he bought and drank a second can of Cherry Coke from the Seven Eleven on the corner of his street in Omaha.

  • Economists do not assume that money is everything.

    In any real-life decision, many of the important benefits and costs will be non-monetary. Economists, admittedly, will sometimes try to place a monetary value on these things. It's their social-engineering identity coming out. For example, they might try to quantify the benefits of a new city park by estimating how much the city's residents would be willing to pay per month to use the new facilities. But this doesn't mean that the city and its economic advisors "only care about money" in trying to decide whether the benefits of the new park would outweigh the costs. That's pretty obvious, since a public park is open to all, and doesn't generate money anyway.

Klamer: Such as the new Millenium Park, in downtown Chicago.

Ziliak: Or repairing the Spanish Steps, in Rome.

Maria: I get it. But to me this idea of prudent choice sounds like wishful thinking. People constantly make imprudent, irrational choices. Like sometimes I drink more coffee than I really want.

Paul: Same here. I'm kinda whack right now. I don't always weigh the costs and benefits before I decide to do something. I didn't do much calculating before deciding to come to college, for example.

Maria: And I always ride my bike to class. I never even think of taking the bus.

Ziliak: But Maria, riding your bike may be very prudent! Maybe you've never had a good enough reason to take the bus. It takes time and energy to figure out new ways of doing things: learning the bus schedule, keeping the correct change around, etc. Besides, bikes are cleaner, and give you exercise, too.

McCloskey: You're right. It's surprising how many actions that appear imprudent or irrational to an outsider are actually quite prudent from the decision maker's point of view (forgetting for the moment Paul's little o.d. on coffee).

Paul: I just don't believe that people are always trying to do what's best for them.

McCloskey: Another good point. True. They don't. For one thing, what's "best" for them may include going over the top at the Somme in July, 1916, as some French, British, and German soldiers did, or sacrificing your private fantasies to supporting your family. Not all economics is about selfishness.

Paul: You said "for one thing."

McCloskey: Yes. And as you said, we don't always think everything through. "There is a manifest negligence in men of their real happiness or interest in the present world," said the philosopher Bishop Joseph Butler in 1725. People are "as often unjust to themselves as to others." All the economist assumes is that most, or much, of economic behavior is prudent, not every single act.

Klamer: That we can agree on. A modest prudence.

Internal and external considerations in prudent choice

Paul is contemplating buying a guitar. He hasn't got one now, though he's a pretty good player. (The last one was stolen out of his car.) He's looking at a low-end Gibson acoustic guitar that costs $800. He wants to make a prudent choice. He knows of course that if he buys the Gibson, sweet as it sounds, he'll have to give up some other things, like buying a new computer. As Frost says in the poem, the two roads diverge, and one of them is bound to be "the road not taken."

Paul's choice will be influenced by internal and external factors. The internal factors are his preferences or "tastes." They are his own, internal feelings about what he likes and how much he would value a new guitar relative to other things. For example, Paul might value fifteen minutes of guitar playing as much as one 12-inch pizza with pepperoni. (In his fantasy he's the next Johnny Cash.) Someone else might place a very different value on both guitar-playing and pizza. But for Paul these two activities in these amounts, the fifteen minutes and the 12-inches, are of equal value.

Figure 2.1 Prudent choices are based on internal and external factors [HERE]

The external factors are the resource constraints, the limited means, that Paul faces. They might include the dollar price of guitar as against the price of a new computer, and the limited amounts of dollars and time he has at his disposal. The constraints prevent him from having everything his heart desires. (Notice: "constraints" in economic jargon are those "scarce resources" or "limited means" we keep talking about.) They are objective factors, out of Paul's control and especially outside his head. In a way of talking that economists find annoying, they are what Paul can and cannot "afford."

QuestionsFactors to consider
How much does the guitar cost?Price of guitar (external)
Can Paul literally afford it, if he spent all his income and wealth on it? His income and wealth (external)
What other costs might Paul incur if he bought a guitar, considering the time costs of playing it? Perhaps a lower grade in his history class, the importance of which depends on Paul's taste for good grades (internal)
How strongly does he feel about the guitar versus other things and activities? His tastes (internal)
How much would it cost to buy a new computer, an alternative source of pleasure? Price of computer (external)

Opportunity costs

A very important piece of economic jargon in thinking about Paul's decision is the opportunity cost of buying the guitar. It's important because it summarizes the only correct theory of the "cost" of an action. Scarcity means that every choice is costly because it consumes some of our scarce resources, which means it gives up some other, second-best alternative. Things aren't costly because they are painful to acquire, or because they embody a lot of labor. They are costly because you can't have your cake and eat it, too. As economists like to say, "there is no such thing as a free lunch," since even a lunch whose monetary cost to you personally is $0 will require some of your time and energy, and anyway an expenditure of money by someone. Choosing one thing means not choosing something else. Two roads diverge. You go to college or you get a job in the local MacDonald's. Going to college has the opportunity cost of all the neat stuff you could have bought if you worked at home at MacDonald's full time. The question is: which opportunities do we forgo when we choose to go to lunch or buy a new guitar? What is the road not taken? And what is the value of these lost opportunities? The full cost of a choice just is the expected value of the next-best road not taken, the one you had to give up to take this one. You could have had the pleasures of the other road. Instead you chose the one you did choose---because you expected its pleasures to be even greater, presumably. Economists call the full cost of such a choice the opportunity cost.

The opportunity cost of an action is the forgone benefit of your next-best alternative action.

Note the phrase "next-best." Opportunity cost measures the value to the decision-maker of an action she or he does not take. In trying to decide whether or not to buy a $800 guitar, Paul would be crazy to worry about giving up silly opportunities like the chance to buy 800 packets of chewing gum for $1 each. He's not going to do that, ever. What matters to Paul is the value of his next-best opportunity, the things he would choose to do or to buy with the $800 if he did not buy the guitar. The value of such things is what Paul will lose - the full and only economic cost he will pay - if he buys the guitar.

The notion that cost just is opportunity cost is gigantically important in understanding all sorts of choices. Suppose when you graduate from college you have three things you might like to do: work on Wall Street, go to Africa with the Peace Corps, or go to film school in Rome. Obviously you can't do more than one of these things at a time. Say you've gotten a job offer on Wall Street and from the Peace Corps, and a good scholarship to go to that film school in Rome, too. What do you choose? If your preference ranking is first to last the film school, Wall Street, Peace Corps, then the opportunity cost of film school is working on Wall Street is-the next-best thing. It's not Wall Street plus Peace Corps because you can only do one thing at a time with your scarce self.

In Paul's case, he would give up the opportunity to buy a new computer. In addition, he's likely to get a D+ in History if instead of studying the past he decides to spend his evenings learning to play Nirvana's "The Man Who Sold the World" (it's in truth a David Bowie song, but Nirvana made it popular). So the full cost of Paul's decision to get the new guitar would be $800 plus the benefits he would've gotten from the computer plus the B- he might have gotten in History. The combined value of these last two items is Paul's opportunity cost.

Concept Check 2: What is the opportunity cost of going to college for a year?

Benjamin Franklin was talking about opportunity costs when he admonished his fellow Americans in 1748: "Remember, time is money. He that can earn ten shillings a day by his labor, and goes abroad, or sits idle, one half of that day, though he spends but sixpence during his diversion or idleness, ought not to reckon that the only expense; he has really spent, or rather thrown away, five shillings besides." Ben was a good economist before there was such a thing.

The idea of opportunity cost is helpful---no, absolutely necessary!---for answering many practical questions. For instance, why are most college students young? Answer: from an opportunity cost perspective, older college students face higher costs. A 20-year-old who busses tables at the local Holiday Inn could earn in his home town a princely $8,000 a year, but a 30-year-old who has risen to the position of assistant manager of food service may earn $25,000 a year. For the 30-year-old to go to college full time for a year, giving up the wonderful job bussing tables, the opportunity cost would be $25,000, and probably a good deal more than that, including insurance, pension, vacation, and the like. So the reason most college students tend to be young is not that old dogs can't learn new tricks. It's that old dogs have a higher opportunity cost. The young tend to have lower opportunity costs and thus can more easily suffer their low opportunity cost to attend college. The same is true of older people when a business downturn puts them out of work. Then they go to school in droves, not because they are suddenly and internally hungry for knowledge but because externally the opportunity cost of full-time study has dropped.

Should New York City sell Central Park?
What a shocking idea. But suppose selling it could solve the city's financial problems. Then it would be irresponsible for the city fathers and mothers not to think it through. Central Park measures about 1 mile by 1 1/3 miles, some 840 acres. (An acre is the size of a football field.) It is by far the largest park in Manhattan (though not in New York City as a whole: the Greenbelt, in the borough of Staten Island, covers more than 2,500 acres). If you ask a non-economist what the park costs, he'll probably say "Nuttin', pal; anyone can go to the park. Take the kids." Or she'll say "Whatever it costs to maintain it. You know: mowing the grass, cleaning the lake, police patrol." And yes, she'd be right. Partly. But the full cost of the park (all the opportunity cost) is much greater. What is the next-best use of the land? As a site for commercial buildings. On the southern border, for example, there's Carnegie Hall, condominiums, and luxury hotels a touch away. Commercial land sells for about $100 a square foot in Manhattan. An acre is about 40,000 square feet, so an acre of land in Central Park would sell for about $4 million. (The best farm land in the Midwest, by comparison, sells for about $1,500 an acre.) So the sale value of the whole park is 840 times $4 million, about $2,500 million or, in other words, two and a half billion dollars.

Wow. That sounds like a lot. Would selling Central Park solve New York City's financial woes? No. New York City, boroughs included, has 8.4 million people. So the $2,500 million tied up in Central Park is only about $2,500/ 8.4 = $300 per person. If the City sold the park it could put the proceeds in the bank to earn as much as 5 percent interest a year. That would bring the City a stream of income into the future of only $15 per year per person. New York City spends about 200 times that amount per capita per year on schools, roads, sewers, police, firefighters, and other services. For now, let's be grateful for the nice park. It's opportunity cost---the value in its next best use of the park land itself and the annual maintenance costs of the park---is not enough to justify such a radical measure as selling it off. Clawing back that cost is not chopped liver, but not so much after all. At merely $15 a person per year plus the costs of maintenance, its opportunity cost of Central Park is probably lower than the perceived benefits per person. Now (says the heartless economist), that Greenbelt might be another matter. . . .