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Opportunity Cost and Stock Option Expensing

After reading and participating in the comments of an article over at Arnold Kling's EconLog, I believe I now understand why the issue of stock option expensing is controversial.

The position I laid out in my essay on stock option expensing (which itself was a response to two other articles) is that the exercise of stock options represents a cost to the owners of a company, through share dilution, but is not in any way an expense to the company itself.

The paper by Hall and Murphy (quoted approvingly by Arnold Kling) states that "when a company grants an option to an employee, it bears an economic [opportunity] cost equal to what an outside investor would pay for the option." This is precisely where my disagreement starts.

The concept of opportunity cost is a useful and simple one: Due to scarcity, every action you take precludes the possibility of taking certain other actions. If you purchase a gallon of milk, that same money cannot also purchase apples. If you decide to sleep, you cannot also use that time for studying. If you go into business for yourself, you forgo the wage income you would have earned by working for someone else. The purpose of the concept of opportunity cost is to remind us of the pervasive influence of scarcity and therefore the need to weigh our alternatives consciously in an effort to maximize the value we obtain from our choices.

The problem with the concept of opportunity cost is its name. It uses the word "cost" in an idiosyncratic way, unlike how it is used in other areas of economics and accounting, which makes it prone to confusion. I believe this confusion is at the root of the controversy over stock option expensing.

Let's say you drive to your bank with $1000, planning to open a CD account earning 2% interest. On your way there, you hear a radio advertisement from a competing bank offering 3% interest. You quickly consider this alternative and conclude that a year's investment at your bank would net you $20, but at the competing bank it would net you $30.

A proper application of opportunity cost to this situation is the conclusion that you could earn $10 more by investing at the competing bank. The $10 is the opportunity cost — the difference in outcomes between two mutually exclusive alternatives.

A troubling, but still technically correct, restatement would be that you lose $10, compared to the alternative, by investing at your bank.

If you drop the context — that's the error — the statement becomes you lose $10 by investing at your bank.

This last statement is emphatically not true. You actually do gain $20 at the end of the year, just like the accountant says, and the accountant is a decent, honest, hard-working individual with the numbers to back it up. Just because you might have had more is no reason to deny the fact that you have still gained.

An opportunity cost is not a real cost in the sense of a quantity of time, money, or other resources that must be expended. The concept of opportunity cost is simply and only a reminder to consider your alternatives carefully and to choose the best one. Giving it a monetary value (such as $10) may help in calculation, but mentally associating that value with the notion of a "cost" creates a mental environment conducive to context-dropping.

The concept of opportunity cost does apply to a company considering the alternative of (1) selling stock options on the open market or (2) awarding them to employees. The company should consider the difference in outcomes among each alternative. But when it chooses one over the other, only the actual costs of the alternative it actually chooses are relevant from then on. The fact that the company might have had more by selling the options is no reason to deny the fact that awarding the options to employees does not incur an actual cost on the company.

With this in mind, my essay might be more persuasive.

I've just discovered an article on Catallarchy from September that deals with this same issue, arguing that there's no opportunity cost because the company could issue additional options out of thin air and sell those. I disagree, but only lightly, because the issue of scarcity still exists with regard to any specific batch of shares.

UPDATE 2003-11-14 07:52:00 UTC: Don Lloyd responds:

If the CEO of Ford gives his wife a Ford Explorer, Ford has forgone the opportunity to sell it to a dealer. This seems to me to be an opportunity cost that should be accounted for, but the appropriate value to be assigned is the replacement cost, not the wholesale or retail price. This replacement cost perspective is also one way to look at why stock and options have an opportunity cost of zero.

If the vehicle was originally the property of Ford, but is then given to the CEO's wife, this does affect the financial condition of the company — its inventories have been reduced, which is an actual cost, and should affect its balance sheet. (I decline to take a position on exactly how, because if I did I'm sure I'd start getting e-mail from accountants asking me why I'm such an idiot and where I studied accounting, and I could only tell them that I haven't, ever.)

The vehicle gift is an actual cost, not an opportunity cost. The difference between this case and stock options is that the vehicle gift affects the assets of the company itself, while stock options affect only the company's owners.

Don then goes on to discuss why it's stock repurchase that should be expensed, not options or grants. Go read it, you might learn something. I did.

Tiny Island