TRADE-OFFS AND OPPORTUNITY COST

Making an Assumption Out of You and Me

Whenever you use a factor of production, a cost is going to be incurred. Why? The factors of production are limited, not limitless. As a result, whenever you choose to use land, labor, capital, or entrepreneurship for one purpose, you lose the ability to use it for another. Take a resource like labor—your labor. Say that you can spend an hour writing a book, teaching a class, or weaving a hammock. The choices you face are called trade-offs. Assume you choose to weave a hammock. You can neither teach a class nor write a book in that hour of time. If writing a book is your next best alternative, then economists would say that the opportunity cost of spending an hour weaving a hammock is the hour you could have spent writing a book. Opportunity cost is the next best alternative use of a resource.

Implicit and Explicit Costs

Opportunity cost is sometimes referred to as implicit cost. For any productive activity there are explicit costs like labor, raw materials, and overhead, which are easily calculated, and there are the implicit costs, which are more difficult to assess.

CONSIDERING OPPORTUNITY COST

For example, suppose it’s a beautiful Friday morning and you think to yourself, “I could go to work like I’m supposed to, I could stay home and sleep away the day, or I could fly to Cozumel and hang out on the beach and do some scuba diving.” Assume that you chose to take the trip to Cozumel, but going to work was your next best alternative. What was the cost of your trip? You paid for the taxi to the airport, the plane ticket, an all-inclusive hotel package, and a dive on Palancar Reef. Was that your only cost? No. You also sacrificed the money you could have made working. Opportunity cost is a bummer. Make sure to always count it when making a decision.

MARGINAL ANALYSIS

Economists like to think of people as little computers who always count the benefit of their decisions versus the cost of those decisions. Because you usually make decisions one at a time, economists refer to the benefit of a decision as marginal benefit. Marginal benefit can be measured in dollars or utils, whichever you prefer. Utils are the amount of utility or happiness you get from doing something. They can be converted into dollars easily.

Say that you like to swim laps in the pool for an hour. How many utils do you receive from swimming laps? How much would you have to be paid to not swim laps? If your friend were to keep offering you ever-increasing amounts of money to not swim in the pool, then it is probably safe to assume that the dollar amount you accept to not swim in the pool is at least equal to the amount of happiness or utility you would have received had you taken a swim. If it takes $20 to keep you from swimming, then you value swimming no more than $20. Swimming is worth 20 utils to you.

Marginal cost is a related concept. Marginal cost is simply what it costs to either produce or consume one extra unit of whatever it is you are producing or consuming. Go back to the swimming example. Assume that swimming in the pool has a marginal cost of $5. If you earn 20 utils from swimming, would you pay $5 to earn $20 worth of benefit? Of course you would. Now assume that swimming in the pool costs $20.01. Would you spend $20.01 to earn $20 worth of benefit? Probably not. Economists conclude that you will swim as long as the marginal benefit exceeds or equals the marginal cost. For you that means you will swim as long as the marginal cost is less than or equal to $20. If the marginal benefit outweighs the marginal cost, you would probably do it. If the marginal benefit is less than the marginal cost, you probably would not do it. If the marginal benefit equals the marginal cost, it means you are indifferent.

ASSUMPTIONS IN ECONOMICS

Economists make certain assumptions when they’re talking about their favorite subject. They expect you to know (and agree with) these assumptions. The three big ones are:

Nothing else changes. Whenever economists make an argument such as: “If income taxes fall, then consumption increases,” it should be understood as: “If income taxes fall and nothing else changes, then consumption increases.” Did you catch the difference between the two statements? And nothing else changes is also referred to as the ceteris paribus assumption. Loosely translated, ceteris paribus means “to hold all other things constant.” So as you continue reading the book, remember that all statements about cause-and-effect relationships are made with the ceteris paribus assumption.
People are rational and behave rationally. Another assumption made by economists, and a big one at that, is that people behave rationally. Economists assume that people’s choices are made with all available information taken into account as well as the costs and benefits of the choice. Furthermore, economists assume that the choices make sense. The assumption that people behave rationally is subject to debate among different schools of economic thought, but for most economic decisions it is a useful assumption.
People are selfish. The last assumption made by economists is that people are self-interested. First and foremost, people think of themselves whenever it comes time to make a decision. Pure altruism is not possible in economics. Economists cynically assume that human behavior is motivated by self-interest. For example, a grenade is thrown into a trench with a platoon of soldiers and one soldier sacrifices his life by jumping on top of the grenade, thus saving the others. To economists, this soldier instantly calculated the marginal benefit and marginal cost of the decision, determined that the marginal benefit of saving his fellow soldiers outweighed the marginal cost of his life, and jumped on the grenade as an act of utility, maximizing self-interest. He saved his friends in order to maximize his utility as a soldier.

The assumptions economists make are subject to criticism and debate. Many critics believe that the field has a tendency to be too abstract and theoretical to have any real-world value. The failure of most economists to predict the most recent economic downturn seems to support the view that economics ignores human psychology at its own peril.

Economics is at a turning point as a field of study, and the assumptions that economists hold dear need to be carefully examined. Instead of being tidy, abstract, and mathematical like physics, economics must become a little more messy, complex, and organic, like biology.

Money Talks

consumption

Household spending on new domestic goods and services.