1.2 Key Principles of Economics: Scarcity, Trade-offs, and Opportunity Costs
Regardless of which system an economy chooses for organizing its production and distribution decisions, those decisions are governed by a common set of principles—principles that are the foundation on which this course is built. Understanding these principles will help you interpret news stories about the economy, make decisions about your life, and, importantly, succeed in this course.
Scarcity
The first of the key economic principles is scarcity. Scarcity A situation where limited resources make it impossible to fulfill all of our wants. means that we don’t have the resources necessary to fulfill all of our wants. One of the fundamental assumptions we’ll rely on in our study of economics is that our wants are virtually unlimited. We are born wanting: “Hey you—you in the white coat! It sure is cold and bright out here. Can you turn down the lights and turn up the thermostat?” We die wanting: “Please just give me a few more weeks to be with my loved ones.” In between, we will spend a lifetime working to fulfill our material and spiritual wants, only to replace them with other desires once they have been satisfied: “I like my BMW, but would you look at the lines on that Benz?” We’re fighting a losing battle. Our desires are virtually unlimited, but the means to satisfy them are not. The most obvious resource we’re lacking is cash: Most of us simply don’t have enough money to buy everything we would like. But a lack of money is often just a symptom of more fundamental resource shortfalls. For example, it generally takes some extraordinary ability to become super rich. Most people lack the athletic ability of LeBron James, the technological genius of Bill Gates, the market savvy of Warren Buffett, or the entrepreneurial vision of Jeff Bezos. And plain hard work can’t generally make up for the lack of those talents because, after all, there are only 24 hours in a day, and we have only a limited amount of time on this planet.
In fact, time is one of our scarcest resources. If only we could work more hours to satisfy our material wants. If only we had more quality time to spend with our friends and family. If only we could pack a few extra hours into each day, how much happier we might be! But time is both precious and fleeting. A lack of time can make you wish you could be in two places at once, force you to pull an all-nighter before a psychology final, and make you angry about every second you spend stuck in traffic. In this way, time is the great equalizer: Wealthy people like Buffett and Bezos get the same 24 hours the rest of us do, and still feel the pressure of “not enough.”
Trade-Offs and Opportunity Costs
Because of scarcity, we have to make choices about which desires to satisfy and which to leave unfulfilled. Nobody gets to break the law of scarcity, no matter where they live or what system their economy is based on. We all face trade-offs in that we address some needs at the expense of others. Economists have a special term for trade-offs: Opportunity costs. The opportunity cost What is sacrificed in order to engage in an activity. of an activity is what you sacrifice to engage in that activity. At its most basic, opportunity cost is a straightforward concept. Suppose you’re down to your last $15, and there are two things you really want to do. One is to see the new Deadpool sequel at the movie theater, and the other is to eat a rack of ribs at the local barbecue joint. But each of these activities costs about $15, so you can afford one or the other, but you can’t afford both. If you choose the movie, you lose the opportunity to eat a great meal. If you choose the meal, you give up the opportunity to see the movie. The option you do not choose is the opportunity cost of your choice.
Even poets must make choices: “Two roads diverged in a wood, and I—I took the one less travelled by . . .”—Robert Frost
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It is, of course, true that when you decide to go to the movie, you lose other alternatives as well. With the $15 you spend on your movie ticket, you could have gotten a great rack of ribs. But you could also have downloaded a Lady Gaga album, put a few gallons of gas in your car, or enjoyed a monster-sized half-caf soy latte. It is, however, inaccurate to say that because you went to the movie you gave up a meal, a CD, five gallons of gas, and a latte, because $15 would have allowed you to buy any one of those things but not all of those things. So, when we talk about measuring the cost of what we gave up, we consider the best of the sacrificed options as the opportunity cost. This is why many economists describe the opportunity cost of doing something as “the value of your next-best alternative.”
The concept of opportunity cost applies to individuals, but it also applies to groups—from small groups like households to large groups like countries. For example, because resources are scarce, countries have to decide what they will produce and what they won’t. Not every country can do everything well: If Finland decides it wants to grow bananas, it’s going to have to pump a lot of resources into building, staffing, and heating greenhouses—resources that could have been used to produce other things like softwood lumber and cellular phones. In other words, bananas are expensive in Finland in that they are grown at high opportunity cost. In contrast, bananas are pretty easy to grow in Guatemala, and their opportunity cost is relatively low: Because of its warm climate and a relative lack of skilled labor, the resources used to produce bananas in Guatemala wouldn’t be very productive if they were devoted to growing pine trees or making cell phones instead. Such differences in opportunity costs create natural opportunities for countries to gain by trading with one another: Finland can send Guatemala some of its cell phones in exchange for some of Guatemala’s bananas. That keeps each country from trying to do something that it’s not particularly good at. (That process of exchange is explored in greater depth in Chapter 5 “Free Exchange: Individual and International Trade”.)
Opportunity Cost Is Not About Money
When you talk with your friends about how much something costs, you probably mention money. So, our movie-versus-meal example may puzzle you. Couldn’t we simply say that the movie cost $15 and avoid discussing the ribs?
Economists avoid measuring opportunity cost strictly in terms of money for two reasons. First, as strange as it sounds, money itself does not make us particularly happy. Our money is a contrivance we invented to help facilitate exchange. It has virtually no intrinsic value. It is simply colorful paper, backed by only the expectation that if we accept it in exchange for the things we sell, we will later be able to find someone else to accept it in exchange for the things we wish to buy. That’s particularly true when the thing we’re selling is our labor: We’re generally confident that we’ll be able to use the money we earn to buy clothes and food. If we weren’t, we’d demand to be paid in blue jeans and sushi.
It’s the clothes, and the food, and the other things we enjoy that really matter to us. If you run a $50 bill through the washing machine and it comes out in little linty pieces, you’re probably not upset because you ruined the bill. You’re upset because you can’t use that bill to go out Saturday night with friends, buy books, or pay rent. Fundamentally, the loss of those opportunities is what is important; the loss of fancy colorful paper is not.
The second reason economists sometimes avoid using money as a measure of opportunity cost is because not all opportunities are easily measured in dollars. Suppose it’s the night before your chemistry final. You’re just settling in for some intensive study when friends down the hall stop by to see if you’d like to join them to see The Rocky Horror Picture Show. “We’ve got an extra ticket,” they tell you. “One night only—and it won’t cost you a dime!”
And they’re right—it won’t cost you a dime. But it will cost you time. Once again, you’re facing a tough choice. If you decide to study, you’ll miss a cult classic and some time with your friends. If you go to the movie, you’ll sacrifice valuable study time—time that could easily make a difference in your course grade. The opportunity cost—the trade-off—is very real and very important to you, but it is not easily measured in dollars. So, when you consider your trade-offs, all costs matter, not just those that involve money.
Sheldon Cooper and Opportunity Cost
In this clip from The Big Bang Theory, Sheldon can’t decide which gaming system he prefers. What is the opportunity cost of buying the Xbox One?
Explicit Costs versus Implicit Costs
The distinction between costs that involve an exchange of cash and those that don’t is an important one. Explicit costs Costs that are measured in dollars and that typically involve some exchange of money. are costs that are measured in dollars and that typically involve some exchange of money. Implicit costs Costs that do not involve an exchange of money. are costs that do not involve an exchange of money. Implicit costs can sometimes be difficult to measure, but they are still real costs, and they are still important. When we evaluate trade-offs, accounting for explicit costs is fairly straightforward, but we want to take extra care to account for implicit costs.
Consider, for example, a new program at your university that will provide all students free Subway sandwiches at lunchtime each semester. This may seem like a great deal to you. But is the free lunch program really free to you? After all, Subway isn’t going to give those sandwiches away. One way that your university might fund the sandwich program is by raising your tuition. In that case, the costs are explicit, and those costs represent the other things you might have spent those tuition dollars on—possibly things you might like more than a few hundred sandwiches.
But your university might choose to hold the line on tuition and not pass the cost of the sandwich program along to you explicitly. That doesn’t mean that the sandwich program doesn’t cost you something! For starters, you’re likely to spend lots of time standing in line waiting for your “free” sandwiches. That’s an implicit cost, and it may be very important to you.
You might bear the cost in more subtle ways. Perhaps the expense of the sandwich program forces the university to make cuts elsewhere. Perhaps it will hire fewer professors and, as a result, a course that you’ll need in order to graduate won’t be offered on schedule. Or perhaps your university will cut a mid-morning section of a course you’re planning to take, leaving only a 7:30 a.m. section that costs you hours of valuable sleep.
These implicit costs are very real. They matter to you. But even though they’re a direct consequence of the sandwich program, that fact is not readily apparent to a casual observer. This is because the sandwich program is one of many university programs, and it can be hard to link cause and effect when all those programs get jumbled together. But more important is the fact that it’s hard to account for those implicit costs using dollars because they are opportunities that never materialized. Figuring out the size of those lost opportunities is just plain tough.
False advertising, indeed! Every economist worth his pastrami knows there are no free lunches!
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In the end, though, one conclusion is certain: Your university’s sandwich program is not free. Somebody pays, visibly or invisibly, directly or indirectly, for every sandwich eaten. And that someone is likely to be you. This example demonstrates why the most famous saying in all of economics, popularized by the late Nobel Prize–winning economist Milton Friedman, is, “There is no such thing as a free lunch.” That wisdom, which is often referred to as the “law of no free lunch,” applies to you, your university, and everyone else.
Application 1.1: Even Superheroes Face Trade-Offs
Everyone faces trade-offs. You face them. Presidents face them. Even dictators face them. But you, presidents, and dictators are mere mortals. Could it be that superheroes, with their superpowers, don’t fall prey to the laws of scarcity?
Alas, even superheroes face trade-offs. To illustrate, consider Superman. He can’t be in two places at once. So when Lois Lane is being mugged on the south side of Metropolis, and arch-villain Lex Luthor is kidnapping Daily Planet editor Perry White on the north side, Superman has to make a choice: Will he save Lois, or will he save Perry?
Do I save this one or that one? Even we superheroes can’t be in two places at once!
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If Superman is really interested in saving lives, perhaps he should let Lois be mugged and let Perry be kidnapped, and instead use his powers to benefit even greater numbers of people. What if society put Superman to work plowing fields in impoverished countries, or hauling water to irrigate crops in drought-stricken regions? What if Superman applied his superhuman strength to turning a gigantic turbine, bringing reliable electricity to billions of people—electricity that might save lives by powering dialysis machines and respirators, all the while raising living standards across the globe? That would surely be a better use of Superman’s strength than having him waiting around for an isolated crime or two to occur in relatively wealthy Metropolis.
Because, instead, Superman chooses to fight crime one villain at a time, society loses. And because of the daunting trade-offs they face, Superman and his fellow crime fighters also lose. The demands of the job are so incredible, regardless of what tasks these superheroes undertake, that their chances of having normal relationships are slim. Consider the fact that very few superheroes reveal their true identity to their love interests: To keep their loved ones from being used against them, they’re forced to hide their super-selves from their friends, their families, and the world as a whole, often behind a mask. That lack of openness and honest communication takes its toll. Superman loved Lois Lane, Batman loved Vicky Vale, Spider-Man loved Mary Jane Watson, and Wonder Woman has had many love interests over the years. Yet each of those relationships was a rocky, drawn-out affair, and in the end, only Superman ended up with his true love.
Everyone faces trade-offs, including superheroes. Superpowers may enable superheroes to defy the law of gravity, but even superpowers aren’t strong enough to break the law of scarcity.
See related problem 2 at the end of this section.
Government, Public Policy, and Trade-Offs
The “law of no free lunch” also applies to governments. Some problems, such as pollution and poverty, can be difficult for individuals to solve on their own. Governments can help solve such problems but, like individuals, governments face opportunity costs. A government can’t provide us with everything we desire; its resources are limited, and our desires are not. For a given amount of revenue, your government must decide which goods or services to provide for people and which ones people will have to provide for themselves. A harsh winter that requires government to spend a lot of money plowing highways could mean cutting back on summer programs for children. Buying more tanks and fighter jets for the military could mean less government funding for national parks.
Governments aren’t always the best at solving our problems. In fact, sometimes governments can actually make things worse. A government that expends resources trying to solve problems that people can solve for themselves may be wasting those resources. A government that actually makes things worse through its actions definitely is. Throughout this book, we’ll explore questions of public policy. Public policy The collection of laws, regulatory measures, and actions concerning a particular topic that originates with some body of government. is the collection of laws, regulatory measures, and actions concerning a particular topic, such as the environment or health care, that originates with some body of government.
In other words, public policy concerns the collection of choices the government makes. We’ll spend considerable time evaluating those choices: Is the government using its scarce resources where they can do the most good? Is it applying its powers to improve society? Or is it squandering its resources by applying them to problems that can be better solved in other ways? Further, governments, policymakers, and politicians have their own sets of motivations that may not align well with society’s interests. One simple example is a congressperson who devotes his efforts to pursuing reelection instead of working to pass legislation that everybody agrees is important. The public choice branch of economics applies the same set of tools economists use to study the motivations of buyers and sellers to examine the self-interested behavior of politicians, lobbyists, agencies, bureaucrats, and voters.
Answering public policy questions is hard because many government trade-offs are implicit, which makes them subtle and difficult to measure. Consider, for example, the automobile safety regulation “Click It or Ticket,” which requires people to wear safety belts. One benefit of the regulation is that it encourages people to use the safety equipment in their cars. Consequently, they will be more likely to survive a crash.
What’s the trade-off of the seat belt regulation? It lowers the cost of driving like a maniac. By encouraging drivers to buckle up, the regulation reduces the costs to drivers of being in accidents. For example, they face a lower risk of injury or death, smaller hospital bills, and less pain. Because of that, we can expect some people to drive faster, venture out more often when roads are snowy, and pay less attention while driving. As a result, mandatory seat belt laws actually create more accidents. And people—both pedestrians and occupants of other cars—will die in those accidents. This puts government in the odd position of choosing exactly who it is going to save: “We know the new law will save the lives of drivers who get in accidents, but we also know that the new law will end up causing some entirely innocent people to die in accidents that would otherwise not have occurred. If we pass the law, we save X number of lives. If we don’t pass the law, we’ll save Y number of lives.” Now that’s a deadly trade-off! (Chapter 2 “Cost–Benefit Analysis and the Value of a Life” talks in greater detail about these deadly trade-offs.)
In the case of mandatory seat belt laws, the trade-off is subtle but measurable. The government has numbers to work with: It can compare X and Y and figure out, based on their magnitudes, whether the law produces a net gain. In fact, governments regularly employ economists and statisticians to do just that—estimate how many lives might be both saved and lost as a result of such a policy and make a recommendation based on those estimates.
Sometimes measuring trade-offs can be more difficult. Consider, for example, the U.S. Constitution’s protection of free speech. As a society, we value free speech because it gives us the right to express ourselves without fear of sanction by the government. But free speech doesn’t come without cost; there’s always a trade-off. Free speech gives you the right to speak your mind, but it also gives someone who is loudmouthed, anti-Semitic, misogynistic, and economist-hating the right to speak his. That trade-off isn’t particularly subtle, but the costs and benefits are incredibly difficult to quantify.
Application 1.2: Rolling Out the Barrels, North Korean Style
North Korea isn’t a shopper’s paradise. But oddly, it’s an okay place to go for a beer; it’s been the home of high-quality Taedonggang beer since the year 2000. To fully appreciate the story behind Taedonggang, we need to know how North Korea answers the two questions facing every economy:
North Korea has a command economy, so when North Koreans in 2000 asked, “What will we produce?” the answer was, “Whatever dictator Kim Jong-il desires.” When they asked, “How will we distribute it?” the answer was, “However Kim Jong-il desires.”
So when Kim Jong-il decided North Korea needed a brewery, it got one. In 2000, his officials negotiated with a centuries-old British brewery to purchase a recently closed plant. The plant was dismantled and reassembled in North Korea as the Taedonggang Beer Factory. Production began soon after.
The typical North Korean, however, is very poor and generally drinks cheap but potent rice liquor rather than more expensive beer. In other words, Kim Jong-il imported an expensive, large-scale brewery to satisfy the few people in North Korea wealthy enough to drink beer. This is nothing new to North Koreans: The country has a massive highway system but essentially no cars.
In command economies, the central planners decide what to produce, even if it’s of little use to the people who live there. This North Korean highway would have been just as useful had it been a bike path.
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But even dictators are constrained by scarcity. They have to make choices, and the consequences of those choices can be tough. Take the choice to begin brewing Taedonggang beer. That decision came on the heels of a series of disastrous floods that resulted in a five-year famine in the country. Of the 22 million people living in North Korea in 1994, an estimated 3 million had died by 1998. The famine is officially ended, but quality of life isn’t much better today: In 2011, the government’s Public Distribution System reduced peoples’ daily food rations so drastically that the associated caloric intake fell from 1,400 calories to just 700—about a third of the typical Westerner’s. In North Korea, the government makes distribution decisions down to the last calorie.
The choice to brew Taedonggang, then, comes with this trade-off: Beer is made from food. The barley that goes into Taedonggang could be used to feed a chronically-malnourished people. There is a cost to Taedonggang beer, and unfortunately, ordinary North Koreans bear the brunt of it. But the leaders bear some, too, because in making the decision to brew beer instead of providing food, they’re weakening the very people they depend on to build their highways, patrol their borders, design their missiles, and staff their cult of personality.
In North Korea, the dictator makes the laws. But nobody, not even the dictator, gets to rewrite the law of no free lunch.
See related problem 3 at the end of this section.