Time for a bit of Friday fun before you depart for the long (US) weekend.
Have a crack at this word problem (answer further down the post* — no peeking):
You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric?
A. $0
B. $10
C. $40
D. $50
The question comes from a textbook authored by Robert Frank and Ben Bernanke, and if you got it wrong, don’t worry — so did a bunch of alleged experts.
Five years ago, Paul Ferraro and Laura Taylor put that question to 199 economists and economics PhD students.
The group’s qualifications were solid — 60 per cent of them had taught introductory economics at their institutions, and 45 per cent had attended a top-30 institution.
Yet only 43 of them, or 22 per cent, answered correctly — about the same as picking an answer at random.
Ferraro and Taylor concluded, somewhat dejectedly, that these results confirmed that “modern graduate education may emphasize mathematics and technique to the detriment of economic reasoning,” and that graduate students should be taught better how to apply economic thinking to the real world.
But, thanks to Marginal Revolution, we also came across a paper written in 2006 by Howard Margolis, who revisits the experiment from a different perspective.
According to Margolis, economists answered the above question wrongly for the same reason that you think the right side of this line is longer than the left (they’re actually the same length):
Okay, maybe not the exact same reason.
But Margolis believes not that economists need a better grounding in fundamental economic principles, but merely that economists “are human, hence vulnerable like everyone else to cognitive illusions in unfamiliar contexts, not because professors of economics need better training.”
And after explaining the answer (hang on, we’re getting there) he continues:
So the question Frank and Bernanke pose in their textbook is a really good one for students. It provokes them to see what at first sight is a weird connection and see why, though odd, it is correct. But as a question outside that tutorial context, it is only weird. The cognitive connection needed to make the correct response readily intuitive is unusual, so that even though the concepts engaged (opportunity cost, value of time, consumer surplus) are familiar to any economist, the connections among them do not just “click” into place. …
It makes sense that our brains are organized in a way that inhibits being distracted by contemplation of such questions. It is only under special conditions (here indeed is where training comes in) that focusing on such things as opportunity cost is fruitful.
The basic idea here is that we cannot — nor would it be desirable to — think like an economist all the time. And neither can economists think like economists all the time.
Life would be impossible if we stopped every five minutes to consider the opportunity cost of what we were doing versus something else. Our “cognitive illusions”, and the habits they perpetuate, are quite useful — and economists have them too.
But just because we can’t think like economists all the time, there are still many specific circumstances (or “special conditions”) when such thinking is extremely useful — and in those instances, we should be mindful to avoid the same cognitive biases that influence our behaviour most of the time.
With that in mind, the implications are not that budding economists need better schooling, but that they should learn to recognize when their schooling can be useful and when it is unnecessary. Is that something you can learn in a classroom?
Either way, you’ve waited long enough.
*Here’s the answer, plus an explanation from Ferraro and Taylor:
When you go to the Clapton concert, you forgo the $50 of benefits you would have received from going to the Dylan concert. You also forgo the $40 of costs that you would have incurred by going to the Dylan concert. An avoided benefit is a cost, and an avoided cost is a benefit. Thus, the opportunity cost of seeing Clapton, the value you forgo by not going to the Dylan concert, is $10 – i.e., the net benefit forgone.
And here is why everyone got it wrong, says Margolis:
In FT’s simple problem, you can’t go to both the Clapton concert and its alternative because you can’t be in two places at the same time, not because money to pay for Dylan isn’t available for Clapton. What is needed is the opportunity cost of using time in one leisure activity rather than another. This is not the value of time issue ordinarily encountered in an economic analysis, which usually trades off value of work vs. value of leisure. And since the out-of-pocket cost for the Dylan concert is zero, nothing prompts a subject to think about the price of the concert, though of course $0 is indeed a price. This combination of odd features makes the problem just a bit “translucent” relative to a question where a person doesn’t have to switch dimensions to get to the opportunity cost. The value of the time used to attend the free Dylan concert here is the consumer surplus foregone by not going to the Clapton concert for which you have a WTP of $50 but need to pay only $40. And although consumer surplus is another perfectly familiar notion, no one ordinarily thinks of consumer surplus you could have gotten from the next-best thing you did not choose as the opportunity cost of whatever you did choose, though indeed that is true.
Have a great weekend.
Related links:
Do Economists Recognize an Opportunity Cost When They See One? - Paul Ferraro and Laura Taylor
Are Eonomists Human? - Howard Margolis