This blog-post is a continuation to:
"Meconomics": ME-Economics
Meconomics: Fear of Missing Out and Opportunity Cost
Read the above posts first for context.
In the previous post I had a look at the concept of opportunity cost and how we ‘make use’ of this concept in our language and daily living, or in other words – how the concept of opportunity cost is embedded in our psychological make-up and how it plays a role specifically when we make decisions. We saw that opportunity cost involves a dimension of a sense of ownership towards ‘the road not taken’ – where it then feels that we are ‘losing’ that option when we choose something else. We also looked at the role imagination plays within the creation of this sense of ownership.
So now, let’s have a look at an example of opportunity cost in economics and then take our understanding of the psychological origin of the concept – as how it exists within ourselves – to re-assess the ‘place’ of opportunity cost in economic situations.
Let’s take the example of interest:
“Interest is compensation to the lender, for a) risk of principal loss, called credit risk; and b) forgoing other investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to pay for them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. In economics, interest is considered the price of credit.”
So, part of why you pay interest on a loan is to compensate the lender for the opportunity cost they incur by borrowing you the funds. The lender’s opportunity cost stems from the idea that he/she could have invested the funds and would have made a profit through investments. When reading this information for the first time it might intuitively sound like ‘it makes sense’ – because as we have seen in the previous post, we can all relate to the experience of opportunity cost. But does it really make sense?
When you’re struggling to decide which shoes to buy and end up choosing one pair over another and you experience a sense of ‘loss’ towards the pair you didn’t buy (your opportunity cost) – who compensates you in monetary terms for that opportunity cost? Do you ask the shopkeeper for a discount as compensation for your opportunity cost, because you could have bought the other pair? You don’t. And in this example we see that it clearly wouldn’t make sense to either.
We understand that when buying something and we have to decide between two options where only one can be taken – that making a decision involves letting go of the other one – it’s simply part of the nature of decision making. Even though we for a moment imagined owning both pairs, we do ‘come back to reality’ so to speak and see that we can only own one and that the other ones are not ours and stay at the shop.
So – why is it any different with lending money? A lender might imagine making a profitable investment on the one hand and lending the money on the other hand. But when it is time to decide – the road not taken is simply that: the road not taken. Once the lender decides to lend the money, it means he didn’t decide to make an investment and so that means he doesn’t get to make a profit either. That was the decision made and the lender could simply take responsibility for their decisions instead of ‘making a financial claim’ to the profits they could have made. Because remember – it’s not because the lender ‘could have made a profit by investing’ that the lender would have. What if, had the lender not borrowed the funds, he instead used the funds to make a really bad investment and lost all his money? That would be equally possible. Should a borrower then be paid a fee of gratitude because the loan potentially prevented the lender from losing his money through a bad investment? Lol – that somehow doesn’t happen.
So – we can ask ourselves why it is okay for a lender to make a ‘real claim’ (meaning: it is expressed in monetary terms, that means someone pays it, that means it has actual consequences on their purchasing power and living arrangements) on a cost that is based in imagination – but in other situations we can’t? Another way to place that question is: why do we allow it? Why have we never questioned it? Is it because we secretly WOULD LIKE TO be compensated for our imaginary losses? Because we secretly WOULD LIKE TO have it both ways without taking responsibility for our decisions?
It opens up even more questions as we look at: how could we do it differently? What other lending and borrowing models could we create? What would be their foundation? Or will we simply keep it as it is and allow such a significant point to be founded on a ‘glitch’ of our own logic?
This topic was also discussed in a Google Hangout – so for more information – check out:
"Meconomics": ME-Economics
Meconomics: Fear of Missing Out and Opportunity Cost
Read the above posts first for context.
In the previous post I had a look at the concept of opportunity cost and how we ‘make use’ of this concept in our language and daily living, or in other words – how the concept of opportunity cost is embedded in our psychological make-up and how it plays a role specifically when we make decisions. We saw that opportunity cost involves a dimension of a sense of ownership towards ‘the road not taken’ – where it then feels that we are ‘losing’ that option when we choose something else. We also looked at the role imagination plays within the creation of this sense of ownership.So now, let’s have a look at an example of opportunity cost in economics and then take our understanding of the psychological origin of the concept – as how it exists within ourselves – to re-assess the ‘place’ of opportunity cost in economic situations.
Let’s take the example of interest:
“Interest is compensation to the lender, for a) risk of principal loss, called credit risk; and b) forgoing other investments that could have been made with the loaned asset. These forgone investments are known as the opportunity cost. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefit of using the assets ahead of the effort required to pay for them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. In economics, interest is considered the price of credit.”
So, part of why you pay interest on a loan is to compensate the lender for the opportunity cost they incur by borrowing you the funds. The lender’s opportunity cost stems from the idea that he/she could have invested the funds and would have made a profit through investments. When reading this information for the first time it might intuitively sound like ‘it makes sense’ – because as we have seen in the previous post, we can all relate to the experience of opportunity cost. But does it really make sense?
When you’re struggling to decide which shoes to buy and end up choosing one pair over another and you experience a sense of ‘loss’ towards the pair you didn’t buy (your opportunity cost) – who compensates you in monetary terms for that opportunity cost? Do you ask the shopkeeper for a discount as compensation for your opportunity cost, because you could have bought the other pair? You don’t. And in this example we see that it clearly wouldn’t make sense to either.
We understand that when buying something and we have to decide between two options where only one can be taken – that making a decision involves letting go of the other one – it’s simply part of the nature of decision making. Even though we for a moment imagined owning both pairs, we do ‘come back to reality’ so to speak and see that we can only own one and that the other ones are not ours and stay at the shop.
So – why is it any different with lending money? A lender might imagine making a profitable investment on the one hand and lending the money on the other hand. But when it is time to decide – the road not taken is simply that: the road not taken. Once the lender decides to lend the money, it means he didn’t decide to make an investment and so that means he doesn’t get to make a profit either. That was the decision made and the lender could simply take responsibility for their decisions instead of ‘making a financial claim’ to the profits they could have made. Because remember – it’s not because the lender ‘could have made a profit by investing’ that the lender would have. What if, had the lender not borrowed the funds, he instead used the funds to make a really bad investment and lost all his money? That would be equally possible. Should a borrower then be paid a fee of gratitude because the loan potentially prevented the lender from losing his money through a bad investment? Lol – that somehow doesn’t happen.
So – we can ask ourselves why it is okay for a lender to make a ‘real claim’ (meaning: it is expressed in monetary terms, that means someone pays it, that means it has actual consequences on their purchasing power and living arrangements) on a cost that is based in imagination – but in other situations we can’t? Another way to place that question is: why do we allow it? Why have we never questioned it? Is it because we secretly WOULD LIKE TO be compensated for our imaginary losses? Because we secretly WOULD LIKE TO have it both ways without taking responsibility for our decisions?
It opens up even more questions as we look at: how could we do it differently? What other lending and borrowing models could we create? What would be their foundation? Or will we simply keep it as it is and allow such a significant point to be founded on a ‘glitch’ of our own logic?
This topic was also discussed in a Google Hangout – so for more information – check out:
