Opportunity Cost and The Broken Window Fallacy

Let's sit down with a man named Frederic Bastiat. He has a story to tell us about a rowdy little kid and a broken window. A story that will change the way you think about the economy.

Once upon a time, there was a man whose son broke a window.

Naturally, the man was very upset because he would have to pay to replace it.

The townspeople, however, gathered around and said that this was actually a good thing! Since the man would have to pay the window repairman, who would then have more money to pay the baker, the butcher, and the candlestick maker-  the community would be better off, right?

But in reality, the man had to use the money he was saving for a new pair of shoes. Since he spent the money on a new window, he could not buy a new pair of shoes. And since the shoemaker missed out on this sale, the shoemaker in turn had less money, and the local economy missed out on that jump start.

So instead of having a pair of shoes AND a window, the man only now had a window, and the same amount of money went into the local economy that would have otherwise- just in the form of a window rather than a pair of shoes. The community was not actually better off!

The broken window fallacy is usually used to illustrate that war, by nature, cannot be a positive thing for an economy. Money spent on a bomb cannot be spent again on a hospital; a building flattened by the enemy would have been demolished by its owner had the owner deemed it an efficient thing to do.

I'm not going to get too much into that, though, because with this blog I want to explore what economic concepts mean to our daily personal finance choices.

The main character in this story is opportunity cost. Opportunity cost is the value of the next best option when you have a choice to make. In this case, the opportunity cost of replacing the window was buying a new pair of shoes. The man only had money for one or the other.

Opportunity cost is invisible, but it's a key player in all of our decisions: not just our financial decisions. Every day you wake up and go to work, you're giving up the next best option, which is staying in bed. Staying in bed is your opportunity cost.

It's important to remember opportunity cost every time you have a choice to make, even if that choice doesn't feel like much of a choice.

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