Wednesday, October 12, 2011

Opportunity Cost: To Be or Not to Be an Economist ...That's the Question

Frederic Bastiat in his essay entitled "What is Seen and What is Not Seen" wrote that the difference between a good economist and a bad economist is that the bad economist only focus on the direct immediately observation consequences of one action, decision, or policy. On the other hand the good economist takes into account also the long term, not immediately observable effects of that action, decision, or policy. Sometimes, some policies have immediate benefits but can lead in the long run to costs that will outweigh those benefits. At other times, some policies have immediate costs but will lead to long run benefits that will outweigh those costs.

Bastiat's statement is easily applicable to the concept of opportunity cost. The difference between the economist and the non-economist is that the economist will take into account the opportunity cost in the decision-making process. As in one comment I made, there are countless of arguments for policing or regulating markets because they are imperfect, they aren't like the textbook perfectly competitive market. Because, there are opportunity costs in trying to make markets resemble the perfectly competitive markets. A quote I often use is the one by Ronald Coase criticizing the use of the perfectly competitive market as a benchmark for regulating markets (fixing those market failures): "Until we realize that we are choosing between social arrangements, which are all more or less failures, we are not likely to make much headway" (1969). The perfectly competitive market model is a useful model to study why market fails, why you have profits, why you have losses, etc. But it's a very poor tool to be used for normative purposes. This is what Harold Demsetz called the Nirvana Fallacy.

To follow up on a post I read quoting the Naked Economics's author Wheelan, what Wheelan doesn't mention at least in the quotes is that economists and market participants are well-aware of these asymmetric information problems but as Kenneth Arrow mentioned in the postscript of his first article discussion asymmetric information (moral hazard) and healthcare, there are many market institutions that have emerged and been developed to mitigate these problems. Akerlof also points to these mechanisms such as warranties and certifications to mitigate the problems associated with adverse selection. Myself when I buy an used book online, sometimes in another country, I know that the seller might lie about the book condition or might not even mail me the book after I enter my credit card number but there are market mechanisms that I can use to prevent this. I can read the previous customers ratings and reviews.

And even if these mechanisms were absent, one should wonder what the government can do better that markets can't (I encourage you to read that opinion piece by Gary Becker from the WSJ from early september here:
If market fails because human beings are faillible individuals with asymmetric information problem, why government will not where markets have. Governments also consist of faillible human beings. To quote Milton Friedman, because governments also fail, often the solutions that the government provide to these market problems tend make the problems worse than the problem itself and even if they didn't (which is extremely rare), there are opportunity costs. How significant is the problem and what is the opportunity cost of fixing the problem. I mentioned in a previous comment about the sustainability issue and global warming. There is indeed global warming but how significant is it? What will be the benefits of slowing down global warming? What are the costs? But more importantly what are the opportunity costs of slowing down global warming? The millions of dollars that could be used to rely on geo-engineering to send into the atmosphere SO2 to cool down earth could be used in other alternative uses such as R&D on drugs to cure cancer or a HIV.

I also want to follow up on a comment about opportunity cost and the impact of innovation and globalization. Innovation is largely the results of the specialization process, the division of knowledge and accompanying increase in productivity & economies of scale allowing the lowering costs of production. Similarly, globalization which is nothing more than the increasing interdependence between individuals, firms, regions, nations resulting from the fact that trade allowed people to specialize where they have a comparative advantage. But, if anything, with the increasing specialization, division of labor and knowledge, more markets have emerged (you have markets for dog walkers, wedding planners, house sitters, etc) where people can specialize themselves where they have a comparative advantage thus lowering the costs of goods and services produced because specialization has allowed for that by increasing productivity, having economies of scale, innovation, and thus lowering cost of production. So the results of this increasing interdependence between people, firms, regions, and nations also increased the opportunity cost for one not to rely on his/her neighbors to get the goods or services is not providing. The time that it will take to any of us to assemble an iPhone compare to the time it takes a Chinese worker to do so would be better use developing new models, new technologies, new drugs, etc. Similarly, the time it would take a Chinese worker to develop a new drug (U.S. is among the top developer of pharmaceutical drugs) could be spend assembling hundreds if not thousands of iPhones.
Now because of this increasing opportunity cost associated with specialization and the ensuing globalization, we are indeed more dependent of our neighbors. As a student in my class asked me this morning, is this a bad thing. The answer is while we are engaging in trade with our neighbors, we are not waging war against them. I believe (my opinion) that's why Mises relabeled Ricardo's Law of Comparative Advantages, the Law of Association. Trade allows for division of labor and knowledge, which allows us to specialize where we have a comparative advantage and rely on our neighbors to get the goods and services we are not producing and them to rely on us to get what they can't produce. But ultimately, trade and division of labor and knowledge allow for us to associate ourselves with people we share little with only the desires to get goods and services they produce but this association is peaceful because they want the same from us. Ultimately, everybody is better off (some more than others but that's not what matters. What matters is that everybody wins). Trade and Specialization lead to peace and where there is no trade, often there is poverty and often it leads to plunder.

To conclude, I reiterate what I say at the beginning. The difference between an economist and a non-economist is that the economist (at least good ones) understands that "There ain't no such thing as a free lunch!" Even a free lunch has an opportunity cost!

Alexandre Padilla


  1. I just wiki'd so many things. Names, in particular. You really got this subject on lock, lol.

    -I would argue that understanding the concept of opportunity cost is a trait of any sensible person, not necessarily a good economist. I would say it is _a_ difference between a good economist and a bad economist, but is by no means a lonely difference.
    -Could you explain what you mean by "normative purposes" in paragraph two? Anyways, I understand the zeal involved in trying to model the world in idealistic typologies, but aren't these idealistic typologies tools we use to formulate conclusions? Surely they are not definitive, but I do believe that they are nothing less than a boon.
    -I really like your example of market mechanisms. That is, the example where we can use the market mechanism of user reviews to determine the reliability of a firm or individual. The establishment of market mechanisms such as these could be a goal of policy makers.


  2. Usually in economics the term "normative" is applied to mean an expression of value judgement, what "ought" or "should" be, as opposed to the term "positive" which relates to reality or what actually *is*. Saying that taxes on the rich should be higher because the poor people need more food stamps is a normative statement, because it expresses an opinion and a set of values.

    I think what Alexandre is saying in that second paragraph is that you cannot use the fact that real life free markets aren't ideal as a means to express value judgements about free markets. ("They are bad, they are good, they need to be regulated.") You *can* use the ideal market as way to establish economic axioms, such as, if the price of a good increases, other things held constant, the demand for that good will decrease.

    There are my two cents. Alexandre can correct me if I'm off base.

  3. Samuel is correct but I think Khrisstian's question shows that (1) first I was unclear and (2) touches on the question what's the role of these abstract constructions we use in economics such as the perfectly competitive market.

    When I talked about normative purposes, I mean to derive economic policy recommendations or conclusions. For example we know that the world in which we live is not a world of perfect and complete knowledge contrary to what we assume in the perfectly competitive market. Because of that you have issues such moral hazard and adverse selection where people who have the knowledge can take "advantage" of people who are not as knowledgeable. This is what economists define as a market failure. It's called this way not because markets do fail but because markets don't resemble the perfectly competitive market we discuss in textbooks. The fact that real world markets are not like doesn't mean that government must intervene "to correct" these markets. Economics have show starting with Adam Smith that we, human beings with all our imperfections, have succeeded in devising mechanisms to mitigate these problems. Economists again starting with Adam Smith that while despite our self-interested nature, reputation is a powerful mechanism to keep our self-interest in check.

    Now these imaginary constructions do have a role in economics but not the one of serving a norm (a reference, an objective) of what we want to achieve but rather as tools to identify phenomena. For example, what happens when you don't have equal access to resources like hypothesized in the perfectly competitive market, you have barriers to entry and natural monopoly. Another example is the one that shows that market forces automatically adjust when you have excess or shortage somewhere so equilibrium price and quantities are stable until an exogenous force such as change in preference create a demand shock or supply shock and the market will automatically adjust. But this to happen, you need several assumptions: information is complete and perfect, property rights and contracts are well-defined and well-enforced. Externalities (such as pollution)are often the product of not well defined (and also sometimes) not well enforced property rights. Does that mean that the government must correct that failure? No, not necessarily, as Ronald Coase showed, when transaction costs are low, people will have incentives to negotiate to obtain an outcome that will benefit all parties. In an ideal world policy makers should think this way but in the real world policy makers tend to respond to different incentives and constraints than market participants do. Policy makers often tend to ignore opportunity costs (trade-offs).

    I do want to conclude on the first part of your comment. That's correct you would like everybody to take into account opportunity costs when they make decisions or support a policy as opposed to another one. Overall, you would like everybody to have some basic knowledge of economics such as incentives matter, there is no free lunch, and demand curves slope downward and supply curves slope upward. You would like people to understand that free trade is a good thing and that taxes, price controls, and prohibitions have unintended consequences and create deadweight losses. In an ideal world you would like people to know this at the minimum. In the real world, most people think minimum wage laws are great and we should tax rich people, and protect our domestic industries against for these foreign industries that are more competitive than we are. People don't see or won't see the unintended consequences, costs (direct & indirect) of doing these things.

  4. -Ah, so you would say the adept usage of the concept of opportunity cost is the major defining characteristic of a good economist? If so, I'd totally agree.
    -I understand you opinion is far more refined, but it is still of my experience that people are good at determining their opportunity cost. However, surely there is still policy and social phenomena that does not minimize opportunity cost, or perhaps even increases it. I would attribute this to the very immature nature of society: collectively, we are still very young and naive when it comes to economics. Nevertheless, I do believe that we have the potential, today, to ascend towards nirvana. It all depends on what you would call a good understanding of opportunity cost. Perhaps a good understanding is a perfect minimizing of opportunity cost. I would say, rather, that a good understanding is a better understanding of yesteryear. I am no means qualified to make inferences on the development of collective economic knowledge, but perhaps you are. Do you think things are getting better?
    -As for current issues. There will always be current issues. There will always be something that can be improved. My question for you is: if we do affirm current issues like (but not necessarily) "tax rich people" will we suffer worse consequences that we did when we have affirmed past issues? That is, are the consequences of our ignorance more or less grave today than it was in the past?

    I have to go and I didn't proofread this so I might have made some stupid statements or arguments. <.< Thanks for humouring me..!!

  5. I would argue that there are three things that are necessary to define a good economist WHEN IT COMES TO DERIVE ECONOMIC POLICIES. A good economist will understand:
    (1) There are tradeoffs (opportunity costs)
    (2) There are visible immediate consequences and not immediately observable long consequences to any decision made.
    (3) Statistical significance doesn't mean economic significance. It's not because there is a statistically significant relationship between two variables (let's say increase access to broadband internet & sex crimes) that it's economically significant.

    I am not certain people are good at determining opportunity cost and tradeoffs. Think about people you might see in the street making you sign petition for less pollution or who wants "free" healthcare or higher taxes to fund education. They rarely understand the opportunity cost associated with these decisions beyond the consequences.

    As for minimizing opportunity costs, it's highly dependent of supply and demand but also, I would argue, of the institutional & political environment in which you live. For example, minimum wage laws contribute to increase the opportunity costs for low productivity individuals to stay in high school. On the other hand, illegal immigration lowers opportunity cost of staying in high school (if you can't see why immediately, it's a good exercise for SWEET members to think about it).

    I believe the consequences of taxing rich people are highly dependent of the current economic environment. When the economic environment is similar to the one we have now, yes, the outcome will be worse. In an economic environment with high GDP, low unemployment, it might not matter as much. And it all depends what we call rich people. Rich people is highly relative. By world standard, I am very rich and actually most if not all Americans are rich. In US standards, I am not rich but I am not poor. It's highly relative.

  6. (1) and (2) agreed. (3) I don't really get what you were trying to say, but my experience is that people tend to define their statistics to represent certain things. We can make assumptions off of these certain things, and even generalize conclusions to be applied. However, any solid statistical argument usually compares two more statistics. More generally, any solid, non-circular argument contains more than two pieces of axiomatic information.

    I can acknowledge the number people in my local area, but Sherri Wall's Econ 100 class has more students than that. I can't really acknowledge the ratios between groups elsewhere, though, since am not very familiarized with the contexts.

    I agree, like a lot of things, "rich" is a term we define to be part of a spectrum. Therefore, our definitions of it are very subjective. Nevertheless, I would argue that there is an optimal way to define to rich for a given legal situation. Discovering this would require a lot of information and a lot iterating, but we can try to get as close as we can, right?. (<--Something wrong with my perspective here) I think like the most important thing is that a policy on taxing rich would need is to remain flexible for future situations, as the optimal point changes and the subjectivities of richness change.