Conceptual Brief: Cost Displacement

Cost displacement is the general term I’m using for when cost-benefit analysis is confused because a portion of costs are borne by someone other than the person doing the analysis, who may not even be aware of them. We are familiar with this in the form of a negative externality, as when your machine drains its sludge onto your neighbor’s land instead of yours. That is, the familiar part is how you are wronging your neighbor; what we forget is that your cost benefit analysis is going to be totally wrong if you do not account for this cost as a cost. You will incorrectly identify optimal efficiencies because your scale of returns will be using the wrong denominator.

Say you have to choose between using two machines, one which costs $8.00 per unit of production, and another which costs $7.00 per unit of production but imposes a cost on your neighbor which we can estimate at $4.00 per unit. You can see where I’m going with this: Quite apart from having wronged your neighbor, if you produce a thousand units and sell them for $10.00 each, you will be comparing net profits of $2000.00 from the $8.00 machine with $3000.00 from the $7.00 machine. Your return on investment for the run of production on the $8.00 machine will be 25%, for the $7.00 machine it will be over 43%! However, a full reckoning of the costs reveals that the $7.00 machine has a net negative utility: That your run of production has done more harm in the form of externalities combined with normal costs, than it has done good in the form of production and satisfaction of desires. You have actually (if these values are correct) done a run of negative production, as if you were merely out vandalizing things. But because the nominal, partially calculated profits are high, your cost-benefit analysis is quite likely to mislead you into considering the $7.00 machine the optimal, productive method!

Critically, externalities like pollution or accidental consumption of nearby resources are not the only means by which Cost Displacement can occur, leading to incorrect behavior. Subsidies are the other great, unrecognized offender, and I intend to elaborate on both categories in the coming months.

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