August 20th, 2015
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As I approach each weekend, I often think about the list of things I need to do as compared to how I could spend time with my family having fun. It is often a tough choice! I have work to do for my business endeavors that can lead to income and profits. I also have activities that I would like to enjoy with my family. As I ponder this each week, I consider the costs and benefits of my alternatives. However, these choices go beyond the value of revenue from working on business items or the cost of tickets to see a movie with my kids. The choices incorporate all of the costs and benefits of the alternative uses of my weekend resource (free time). Although I try to strike a balance, I am always reminded of a key concept in economics (and human incentives) – “opportunity costs.”
Day to day human behavior (choices as determined by individual preferences) transforms scarce means into ultimate ends (standards of living). Since scarce resources have alternative uses, how people in a society make choices (interactions and exchanges) has a significant impact on their ultimate standard of living. Indeed, human behavior is directed by incentives; therefore, the economic system that is most consistent with human behavior, will result in the most effective use of scarce resources (“effective” in terms of maximum satisfaction).
In light of scarcity, individuals are forced to decide what they want most, given the resources they do have, and make choices. Each person must determine their unique preferences, make trade-offs and sacrifice one thing for another. In other words, scarcity requires individuals to economize. If one economizes effectively, they maximize their satisfaction given their limited resources. This is the heart of economics.
Opportunity cost is a key concept in economics, and has been described as expressing “the basic relationship between scarcity and choice.” Opportunity Cost is “a benefit, profit or value of something that must be given up to acquire or achieve something else.” Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice or decision has an associated opportunity cost. The opportunity cost of any choice is the value of the benefits one could have received by taking an alternative action (which has been forgone). Using this concept, value can be observed even without money or prices (in terms of money).
Think of it this way, if there are two uses for the resource “X”, either “A” or “B”, the opportunity cost of using “X” for “A” is “B” and the opportunity cost of using “X” for “B” is “A”. For example, the true economic cost of attending college includes more than the price of tuition, housing, books, etc. The economic cost of college includes the opportunity cost of not working while you are in school (in terms of the income you have forgone). In other words, resource “X” could be your time. If you use it to do “A” (study), you can’t do “B” (work). Therefore, by choosing to get a college education, you are losing the possible income (say $24,000+) that you could have earned by working instead of going to college. Hence your opportunity cost includes the $24,000+ of lost income, plus the value of the alternative uses of the money you spent (on tuition, housing, books, etc.).
In our example of the “fisherman” and “waterman” on the island (see ECONOMIC CONCEPT: THE DIVISION OF LABOR – WHY IT PAYS TO BE SPECIAL!), the opportunity cost for each person is the time, fish or water forgone by pursuing alternative activities. Just to recap, each person needs 3 fish and 1 pail of water to survive each day. The fisherman can catch 1 fish per hour and can fetch 1 pail of water in six hours. As for the waterman, he catches 1 fish per 2 hours and fetches a pail of water in 3 hours. For the “fisherman,” the opportunity cost of 1 pail of water is 6 fish (or six hours of leisure), since he can catch 1 fish per hour and retrieve 1 pail of water in six hours. Consequently, his opportunity cost of 1 fish is 1/6 a pail of water. For the “waterman,” his opportunity cost of 1 pail of water is 1.5 fish (or 3 hours of leisure). Therefore, the opportunity cost of fish for the waterman is 2/3 a pail of water (or 2 hours of leisure). These different opportunity costs will incent the fishermen and waterman to allocate their resources (time and labor) in different ways. Since the opportunity cost of fishing (in terms of water, 1 fish = 1/6 pails of water) is lower for the fisherman, he should spend his labor time fishing. Likewise, since the opportunity cost of fishing (in terms of water is 1 fish = 2/3 pails of water) is higher for the waterman, he should spend his labor time fetching water.
Now you may be asking why I’m harping on this distinction of opportunity costs versus prices. Last week, I pointed out the benefits of the division of labor and specialization. Individuals, groups, businesses and countries specialize in particular ways, often because of the unique opportunity costs they face. As you consider your choices in life, don’t forget to consider your opportunity costs!
Next week, I will connect the concepts of “division of labor” and “specialization” with the concepts of “absolute and comparative advantage,” using this concept of “opportunity costs”. Stay tuned, it’s important to The Future of Your Wealth!