Intro to Econ: Opportunity Cost

Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.

Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers and businesses.

One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.

The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.

Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.

Opportunity Cost

When an option is chosen from alternatives, the opportunity cost is the “cost” incurred by not enjoying the benefit associated with the best alternative choice. The New Oxford American Dictionary defines it as “the loss of potential gain from other alternatives when one alternative is chosen.”

In simple terms, opportunity cost is the benefit not received as a result of not selecting the next best option. Opportunity cost is a key concept in economics, and has been described as expressing “the basic relationship between scarcity and choice”. The notion of opportunity cost plays a crucial part in attempts to ensure that scarce resources are used efficiently.

Opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered an opportunity cost. The opportunity cost of a product or service is the revenue that could be earned by its alternative use. In other words, the opportunity cost is the cost of the next best alternative for a product or service. The meaning of the concept of opportunity cost can be explained with the help of the following examples:

1. The opportunity cost of the funds tied up in one’s own business is the interest (or profits corrected for differences in risk) that could be earned on those funds in other ventures.
2. The opportunity cost of the time one puts into his own business is the salary he could earn in other occupations (with a correction for the relative psychic income in the two occupations).
3. The opportunity cost of using a machine to produce one product is the earnings that would be possible from other products.
4. The opportunity cost of using a machine that is useless for any other purpose is nil since its use requires no sacrifice of other opportunities.

Thus opportunity cost requires sacrifices. If there is no sacrifice involved in a decision, there will be no opportunity cost. In this regard, the opportunity costs not involving cash flows are not recorded in the books of accounts, but they are important considerations in business decisions.

Examples of Opportunity Cost

• The cost of war. If the government spends $870bn on a war, it is $870bn they cannot spend on education, health care or cutting taxes / reducing the budget deficit.
• Spending on new roads. If the government build a new road, then that money can’t be used for alternative spending plans, such as education and healthcare.
• Tax cuts. If the government offers an income tax cut, the opportunity cost is that government revenue cannot be used to finance some aspect of government spending.
• Time. If you have 12 hours at your disposal during the day, you could spend these hours in work or leisure. The opportunity cost of spending all day watching TV is that you are not able to do any study during the day.
• Enter the workforce at 16. If you enter the workforce at 16 without qualifications you start earning money straight away. But the opportunity cost is that you lose out on the potential of getting better qualifications and possibly a higher salary in the long-run.

Production Possibility Frontier

Production possibility frontier is the graph which indicates the various production possibilities of two commodities when resources are fixed. The production of one commodity can only be increased by sacrificing the production of the other commodity.

The state of technology is taken to be constant. Since the production of one commodity can be increased only by decreasing the production of the other commodity, the production possibility frontier also measures the production efficiency of the commodities. The production possibility frontier helps in deciding the commodities most beneficial to society, but this response is limited in itself as there is a choice between two commodities only.

Comparative Advantage

The law of comparative advantage describes how, under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage. In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.

Comparative advantage describes the economic reality of the work gains from trade for individuals, firms, or nations, which arise from differences in their factor endowments or technological progress. (One should not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries).

Theory of Comparative Advantage

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries. Widely regarded as one of the most powerful yet counter-intuitive insights in economics, Ricardo’s theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.

Criticisms of Comparative Advantage

• Cost of trade. To export goods to India imposes transport costs.
• External costs of trade. Exporting goods leads to increased pollution from ‘air-freight’ and can contribute to environmental costs not included in models which only include private costs and benefits.
• Diminishing returns/diseconomies of scale. Specialization means a country will increase the output of one particular good. However, for some industries increasing output may lead to diminishing returns. For example, if Portugal has a comparative advantage in wine, it may run out of suitable land for growing grapes. A contemporary example is Mongolia. Mongolia was believed to have a comparative advantage in cattle farming. However, according to Erik Reinert opening of markets to international competition in 1991 led to an increased size of animal herds, but this led to over-grazing and loss of grazing land.
• Static comparative advantage. A developing economy, in sub-Saharan-Africa, may have a comparative advantage in producing primary products (metals, agriculture), but these products have a low-income elasticity of demand, and it can hold back an economy from diversifying into more profitable industries, such as manufacturing.
• Dutch disease. Dutch disease is a phenomenon where countries specialize in producing primary products (oil/natural gas) but doing this can harm the long-term performance of the economy. In the 1970s, the Netherlands specialized in producing natural gas, but this led to the neglect of manufacturing and when the gas industry declined, the economy was left behind its near neighbors.
• Trade – not a Pareto improvement. Trade can lead to an increase in net economic welfare. However, it doesn’t mean that everyone will become better off. Some workers in uncompetitive industries may lose out and struggle to gain employment in new industries.
• Gravity theory. Proposed by Jan Tinbergen, in 1962, this states that international trade is influenced by two factors – the relative size of economies and economic distance. The model suggests that countries of similar size will be attracted to trade with each other. Economic distance depends on geographical distance and trade barriers. The implication is that countries economically close and of similar size will engage in similar levels of bilateral trade. It also suggests trade is more likely between countries which are geographically close.
• Complexity of global trade. Models of comparative advantage usually focus on two countries and two goods, but in the real world, there are multiple goods and countries. Increasingly there is growing demand for a variety of goods and choice – rather than competing on simple price.

Absolute Advantage

In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input. Since absolute advantage is determined by a simple comparison of labor productiveness, it is possible for a party to have no absolute advantage in anything.

Free Goods

A free good is a good that is not scarce, and therefore is available without limit. A free good is available in as great a quantity as desired with zero opportunity cost to society.

A good that is made available at zero price is not necessarily a free good. For example, a shop might give away its stock in its promotion, but producing these goods would still have required the use of scarce resources.

Examples of free goods are ideas and works that are reproducible at zero cost, or almost zero cost. For example, if someone invents a new device, many people could copy this invention, with no danger of this “resource” running out. Other examples include computer programs and web pages.

Earlier schools of economic thought proposed a third type of free good: resources that are scarce but so abundant in nature that there is enough for everyone to have as much as they want. Examples in textbooks included seawater and air.

Intellectual property laws such as copyrights and patents have the effect of converting some intangible goods to scarce goods. Even though these works are free goods by definition and can be reproduced at minimal cost, the production of these works does require scarce resources, such as skilled labor. Thus these laws are used to give exclusive rights to the creators, in order to encourage resources to be appropriately allocated to these activities.

Many post scarcity futurists theorize that advanced nanotechnology with the ability to turn any kind of material automatically into any other combination of equal mass will make all goods essentially free goods, since all raw materials and manufacturing time will become perfectly interchangeable. If there is no opportunity cost in consuming a good, we can term it a free good. For example, if you breathe air, it doesn’t reduce the amount available to other people – there is no opportunity cost.

References

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