“Cost” Is Not a Synonym for “Loss”

by Don Boudreaux on August 6, 2017

in Myths and Fallacies, Risk and Safety

The following distinction between cost and loss is not original, but it is, I think, worth articulating here.  I do so below the fold.

Earthquakes are a threat to life and property in California.  And no one doubts that a major earthquake – one that might very well strike California – can inflict billions of dollars worth of property damage and, worse, kill thousands of people.  Note that the economic consequences of this property damage and loss of life will not be confined only to those individuals whose properties are damaged and to those who lose loved ones in the quake: countless people from around the globe with economic ties to these earthquake victims will also suffer economically (although a relatively small handful, such as citrus growers in Florida, might be net beneficiaries).

Some amount of resource expenditure is possible to eliminate the potential harm from earthquake damage in California.  Most obviously, people can move themselves and their businesses out of California.  All of the current 39.5 million people living there can move to places far less likely to be hit by devastating earthquakes, with no one moving into California to replace its lost population.  Human beings can completely desert California.

Why is there no such mass evacuation of California?  The reason is not that Californians are unaware of the likelihood of being harmed by a severe earthquake.  They are aware of this reality.  The reason there is no mass evacuation is that each adult currently living in California judges that the cost of moving to a less earthquake-prone state or country is greater than the expected benefit of moving.  Being aware of the potential danger and yet nevertheless choosing to bear it means that the cost of any earthquake damage that does happen is internalized on Californians.  Making cost-benefit calculations, Californians judge the expected benefits of moving out of that state to be lower than the costs of doing so.  (For readers who are skeptical of my claim that cost-benefit calculations are at work in this instance, suppose that Californians were told by a reliable source that, if they remain in that state, the chance that they and their families will perish in an earthquake within the next 12 months is 100 percent.  If you understand that nearly all of them will then move out of that state, you in fact are not truly skeptical that cost-benefit calculations are at work in this instance.)

So if and when a devastating earthquake does strike California, is the resulting damage a loss?  The resulting damage certainly is unfortunate and, in some cases, tragic.  It is unquestionably regrettable.  But is it an economic loss?  The answer, I believe, is no.  With people in California having for years internalized the prospect of being victimized by a devastating earthquake, the prices of residential and commercial real estate in California reflects this expectation.  (They are lower than they would be otherwise.)  Likewise, wages and profit rates in California also reflect this expectation.  (They are higher than they would be otherwise.)  So when the ‘big one’ does in fact strike (and assuming that it’s not out of proportion to any earthquake that was humanly foreseen), it’s at least arguable that Californians would not suffer a loss when their economic activities are reckoned over an appropriately inclusive period of time.  Instead, they are merely paying the price for whatever benefits (including lower-than-otherwise real-estate prices and higher-than-otherwise personal incomes) they chose to receive – to “purchase” – by living in California.

Many readers will question this conclusion.  To them I offer a different example.  Callie today buys a new car on credit.  She drives her shiny new car home today but the first payment on it isn’t due until January 1st.  When a few months from now she receives the bill in the mail and pays it, does Callie suffer a loss?  Would anyone conclude that her creditor – or the financial market generally – imposes on Callie losses?  Costs, yes.  But losses?  Surely not.

Now change the Callie example just a bit.  Suppose that on the day she agrees to buy the new car on credit her creditor offers to her the following options: “(1) starting on January 1st, pay each month, for 48 consecutive months, 1/48th of the total price of the car plus market interest on the car loan; or (2) come January 1st you’ll roll dice: if the number you roll is six or less, you’ll own the car outright without ever having to pay a cent toward its purchase price; but if you roll seven or higher, you’ll immediately pay full price for the car but you’ll not own the car; the creditor will take it from you.”

If Callie accepts the option (1) she’s simply commits herself to abide by the terms of a familiar consumer loan.  But suppose that she instead chooses option (2).  Would you call her irrational?  (I wouldn’t.  Who am I to judge Callie’s risk preferences?)  Having chosen option (2) and then rolling the dice to discover that she rolls, say, a nine, she must pay full price for the car but is obliged to turn the keys and title of the car over to her creditor.  Does Callie here suffer a genuine loss?  I think not.  Reckoned over the appropriately inclusive time span – that is, a stretch of time that includes Callie’s decision to purchase the car and choose the creditor’s option (2) – Callie’s cost (having to sacrifice the car to her creditor) is not a genuine loss.  Callie is not made, by her reckoning, worse off.  She did not have to buy the car on credit, yet she chose to do so.  And she did not have to choose option (2), yet she chose that option.  At the time she chose option (2), she weighed the expected net benefit of (1) against (2) and, for her, found the net benefit of (2) to be greater.  To receive this net benefit Callie paid a price – incurred a cost – which, in this case, was to abide by the terms of option (2).  Callie’s obligation, having rolled nine, to turn the car over to her creditor is simply the price that she agreed to pay in exchange for a bundle of expected benefits (in her case, a good chance of getting the car without having to pay any money for it).  A price paid is a cost, but it’s not a loss – at least, it’s not a loss that, when reckoned over an appropriately inclusive time span, makes the person worse off.

“But Callie is worse off!” I hear some readers protest.  To them I ask: Suppose Callie had instead chosen option (1).  Would you say then that Callie is made “worse off” by having to pay each month’s car note?  Of course not.  You recognize Callie’s payment of this car note as a cost but not as a loss.  I see no difference in Callie having to abide by the terms of chosen option (2) than by the terms of option (1) had she instead chosen (1).

So now back to Californians.  I see Californians much as I see Callie: they, in effect, are choosing option (2).  Just as we feel bad for Callie when, having chosen option (2), she rolls nine and loses her car, we feel bad for Californians when, having chosen to live in a state that is especially prone to earthquakes, they suffer the misfortune of a devastating earthquake actually occurring.  We might even, in our humanity, feel so bad for them that we contribute to charitable causes to help them out.  But we would be mistaken to conclude that they incur economic losses as a result of the devastating earthquake.  Their losses are but the prices they agreed to pay in return for the benefits they enjoyed by living in California.

Put differently, the costs borne by Californians from a predictable earthquake are internalized on them.

In a follow-up post I’ll extend this thought experiment to the question of externalities.

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