Opportunity Costs

The concept of opportunity costs seems to be non-trivial, in the sense that most people don’t seem to get it. When I first learnt it as part of my Economics course at IIT Madras, I thought it was fairly common sense. However, looking around at a variety of people, it doesn’t seem to be that common.

A few Sundays back, I came home in the evening expecting an evening full of EPL and IPL (I don’t exactly recall what games were on that night, but both were fairly appetising). And then my mother tells me that I’ve to go for a niece’s birthday party. I wasn’t too enthusiastic about going, but was pushed to go nevertheless. I spent a total of an hour in commuting and attending the party and eating. “So you weren’t bored”, said my mother. “I wasn’t bored as such, but had nowhere as much fun as I’d’ve had with that hour of cricket and football. In fact, even if I take into account the “reputation” and minimal networking and whatever good Karma I gained out of attending the party, I thought I wasn’t adequately compensated. It was hard convincing my mother of the same.

Changing tracks, you have various interest groups clamouring for extra funds from the government for one purpose or the other. On a number of occasions the lobbies are so strong the money will be released. However, I’m yet to see too many people asking the question as to where the money came from. Rather, what would have happened to the money had the government not doled it out to this interest group. In fact, the Finance Minister would do a great service to himself and to most of rest of the people if he starts talking in terms of opportunity costs.

Take the following two statements:

1. “The government has given the textile sector a tax break amounting to Rs. 1000 Crore in the wake of the rupee’s appreciation”

2. “The government has given the textile sector a tax break amounting to Rs. 1000 Crore in the wake of the rupee’s appreciation. The money thus collected was supposed to go into the building of 500 superspecialily hospitals in remote and poverty-stricken districts”

I’m not sure if this example is the best (I mean I think it’s easy to replace most variables in this), but you can see the impact when people start talking in terms of opportunity costs.

The provocation for this post comes from this analysis of a shop called “Amma Naana” in Chennai. The authors of the study, supposedly MBA students and their professors, compare this store to the average supermarket in Chennai. They meticulously collect data, create tables, calculate averages and show this store to be significantly superior to all supermarkets.

I don’t dispute the conclusion at the macro-level. From my experience, too, standalone stores seem to be much better managed than chains, and there is the element of customer service which leads them to do much better than similar “organized retail”. However, certain parts of the analysis are disturbing:

Amma Naana does not pay any rentals as the property is owned by the proprietors.

Supervision of the store involves the owners? family members, keeping the employee payroll lower.

Ok, from a purely Profit and Loss statement standpoint (notice that I’m not saying ‘accounting standpoint’) this might be fine. However, when doing a comparative analysis, isn’t it necessary to take into account the opportunity costs? For example, the article says that the store charges a premium on most products. And all packed goods are sold at MRP. Is anyone surprised about this, given that this store is in the posh Boat Club area?

Usually, how does the poshness of the locality come into account in a P&L statement? By way of high rents. By removing rents out of the equation, this article is completely missing the point. Similarly, this store is supposed to have a larger staff than most chains. However, “most are family members” so their salary is not taken into the income statement. Can any other store operate like this? Does it make any sense to compare this store to another which owns neither the location nor the rights to the labour of a few hundred relatives?

The normal “economic” thing to do would obviously be to take into account the opportunity cost of the space and the relatives. Take in the costs of “what if I’d rented out my building instead of running this shop” and “what if I’d let my relatives work elsewhere instead of running this shop”. And? the analysis will be fine.

But then, these things don’t fit into an accounting standpoint, do they? You remember accounting? People read P&Ls and balance sheets together for a reason. Suppose the account statement presented in the article were accompanied by a balance sheet. The size of the balance sheet would’ve showed you there is significant capital cost involved. The size of equity the promoter owns would have told you that the profits have to be shared with several relatives. Fair?

Sometimes when you see articles with obvious stupidity in newspapers where you expect a reasonable standard, you start wondering who the stupid one is. Whether it is the guy who wrote the article or the editor. I think the prize should go to the editor. The author does his job – writes an article as well as his intelligence permits. The editor? He is bloody paid to keep the bad articles out, and maintain the exalted standards of the publication. Clearly, the editor at the Business Line doesn’t seem to be doing his job.

Hat tip to

?for linking to a link to this article.


Put Comment