I start, then, with fundamentals. The conception of costs in modern economic theory is a conception of displaced alternatives: the cost of obtaining anything is what must be surrendered in order to get it. The process of valuation is essentially a process of choice, and costs are the negative aspect of this process. In the theory of exchange, therefore, costs reflect the value of the things surrendered. In the theory of production they reflect also the value of alternative uses of productive factors—that is, of products which do not come into existence because existing products are preferred.
That was from Lionel Robbins in 1934, “Remarks upon certain aspects of the theory of cost.”
Most business people familiar with economics can give the correct description of opportunity costs, but then go ahead and neglect it in their everyday practice. Costs are not the money outlays recorded by accountants. The cost of a weapons program isn’t the dollar expenditures resulting from budgets. The cost involves the valuation of what alternative objectives could have been accomplished, and is therefore subjective.
Spending, let’s say, $100 million on a fighter jet does not make a unit of the system worth $100 million. Even if much of the reproduction outlays go to materials, fabrication, assembly, and so forth, that is not what makes an end-item valuable per se. Most of the value is found in the platform design, the business practices of the producer, and so forth. Poor choices in design and production methods could result in outputs that are far less valuable than it could have otherwise been. Most of the value of complex modern systems are in the creation of intangible assets.
Simply put, the relative production costs of economic output does not determine exchange values. This should give analysts pause when the use cost and performance data on weapon systems. Having that information tells the observer nothing without knowing the particular circumstances involved in the decisions made on the ground.
Whenever production is uncertain, complex, and requires large scale organizations, there will be an increasing need to delegate decision making to the man-on-the-spot, who can take advantage of local knowledge that cannot be effectively communicated to the higher levels. Many of the choices faced by the man-on-the-spot can have a great impact on project outcomes without being visible in the monetary outlays. Shirking is an obvious example. But suppose there is a better design or cheaper production method. The cost of staying the course could be very high, and that cost could only be recognized if the alternative course were evaluated to be superior. If a competitor pursued the foregone opportunity, then they may gain a marketplace or military advantage.
Here is some additional detail on opportunity cost as expressed by James M. Buchanan.
Simply considered, cost is the obstacle or barrier to choice, that which must be got over before choice is made. Cost is the underside of the coin, so to speak, cost is the displaced alternative, the rejected opportunity. Cost is that which the decision-maker sacrifices or gives up when he selects one alternative rather than another. Cost consists therefore in his own evaluation of the enjoyment or utility that he anticipates having to forgo as a result of choice itself. There are specific implications to be drawn from this choice-bound definition of opportunity cost:
1. Cost must be borne exclusively by the person who makes decisions; it is not possible for this cost to be shifted to or imposed on others.
2. Cost is subjective; it exists only in the mind of the decision-maker or chooser.
3. Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
4. Cost can never be realized because of the fact that choice is made; the alternative which is rejected can never itself be enjoyed.
5. Cost cannot be measured by someone other than the chooser since there is no way that subjective mental experience can be directly observed.
6. Cost can be dated at the moment of final decision or choice.
From this it follows that the opportunity cost involved in choice cannot be observed and objectified and, more importantly, it cannot be measured in such a way as to allow comparisons over wholly different choice settings…
In competitive markets prices tend to equal marginal costs, but do we want to make prices equal ‘marginal costs’ in non-market settings, when we fully realize that marginal costs can only be objectified by the arbitrary selection of some artificially homogenized measure? Do we really want to make one beaver exchange for only two deer when poisonous snakes abound near the beaver dams? Of course not! But how do we know that the snakes are there? Because the beaver hunters think they are?
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