Opportunity Costs: The Parable of the Broken Window
Some people argue that natural disasters and other acts of destruction create wealth and employment as we repair the damage they’ve caused. Professor Dan Russell explains that this fallacy fails to take into “opportunity costs” into consideration. Whenever we use a resource for one purpose, like fixing a window, we give up the opportunity to use that resource for another purpose. We only know if the use of a resource has created value if we compare it with the the alternate uses we had to forego.
The Broken Window Fallacy (video): Art Carden explains the broken window fallacy.
Louisiana Floods Reveal Age Old Broken Window Fallacy (blog article): Don Boudreaux explains how many fell for the broken window fallacy in response to the recent flooding in Louisiana.
How a 19th century French pamphleteer preempted two centuries of economic fallacies (blog article): Christopher Todd Meredith explains Frederic Bastiat’s contributions to economics and political science, including the broken window fallacy.
Opportunity costs, the broken window. Here is a paradox. It seems obvious that disasters destroy wealth, and yet cleaning up after a disaster creates jobs, and creating jobs seems to create wealth. Do natural disasters create wealth, or do they destroy wealth? Frederick Bastiat posed a similar question in his essay on the Broken Window. In that essay, he tells the story of James Goodfellow, and his little boy who breaks a window. Obviously, James is annoyed, but then his neighbor tells him, “Look on the bright side, broken windows create jobs for glass makers, and glass makers create jobs for bakers, and bakers create jobs for wine merchants.” Broken windows create jobs in our neighborhood, and jobs create wealth. There is one grain of truth here; repairing broken windows does create jobs for window makers, but, there is an unseen cost to doing so.
The money that James spends to fix the window could have been spent on a new pair of shoes. That would have instead created a job for a shoe maker, and he too could have created a job for bakers, and wine merchants, and all the rest. There is this difference though, after spending money to fix the window, James will have a functional window, but if the window had never been broken in the first place, then James still would have had a functional window, and he would have had a new pair of shoes as well. The broken window actually made the neighborhood a little poorer. Poorer by the value of a new pair of shoes, or poorer by the value of the broken window, which comes to the same thing. The neighbor’s mistake was that he only saw a job created for a window maker, but he didn’t see what was given up in order to create that job.
He ignored what economists call opportunity costs. Whenever we use a resource for one purpose, like spending money to fix a window, we have to give up the opportunity to use that resource for any other purpose. In order to know whether the use of a resource has created wealth or not, we have to compare it with the alternative uses we had to forego. If the use we make of the resource is more beneficial than the other ways we might have used it, then we have created wealth. If we missed the chance to do something else more beneficial with that resource, then we have destroyed wealth. The amount of wealth we have destroyed depends on how much better off we would have been had we done something else. More technically, the opportunity cost of a use of a resource is the value of the next highest valued alternative use of that resource. Although disasters create jobs, those jobs have extremely high opportunity costs.
Disasters don’t create wealth, they destroy wealth. Why did James’ neighbor make that mistake? That’s really the bigger issue that Bastiat is raising in this essay. I think Bastiat expects that most people who read his essay will start out making the same mistake the neighbor made. We don’t just ignore the opportunity costs of fixing broken windows, we tend to ignore opportunity costs in all sorts of cases, and even on a society wide scale. Why is that? Go back to the broken window. One effect of a broken window is that a job goes to a window maker, and that effect is something that happens, but the other effect of the broken window is that a job doesn’t go to the shoe maker. In other words, the other effect is something that doesn’t happen.
That means that one effect is there for us to see, but the other effect is never there for us to see, and opportunity costs are always effects of that second type. Opportunity costs are hard to see for the simple reason that they are alternatives that never take place. Opportunity costs are things that never happen. That’s why opportunity costs remain hidden in the shadows, just like the shoemaker in Bastiat’s story. I think the really important point that comes out of Bastiat’s essay, is that it takes special effort to train ourselves into the habit of always looking in the shadows for hidden opportunity costs, and that is the central habit of the economic way of looking at the choices that we make.