No Such Thing as a Free Lunch: Principles of Economics (Part 5)

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Henry Hazlitt

The Economic Problem: Scarcity and Choice

(Part B)

by

Charles Lamson

Scarcity, Choice, and Opportunity Cost

In the next few posts, we discuss the global economic landscape. However, before you can understand the different types of economic systems, it is important to understand the basic economic concepts of scarcity, choice, and opportunity cost.

Scarcity and Choice in a One-Person Economy

The simplest economy is one in which a single person lives alone on an island. Consider Bill, the survivor of a plane crash, who finds himself cast ashore in such a place. Here, individual and society are one; there is no distinction between social and private. Nonetheless, nearly all the same basic decisions that characterize complex economies must also be made in a simple economy. That is, although bill will get whatever he produces, he still must decide how to allocate the island's resources, what to produce, and how and when to produce it.

First, Bill must decide what he wants to produce. Notice that the word needs does not appear here. Needs are absolute requirements, but beyond just enough water, basic nutrition, and shelter to survive, they are very difficult to define. What is an "absolute necessity" for one person may not be for another. In any case, Bill must put his wants in some order of priority and make some choices.

Next he must look at the possibilities. What can he do to satisfy his wants, given the limits of the island? In every society, no matter how simple or complex, people are constrained in what they can do. In this society of one, Bill is constrained by time, his physical condition, his knowledge, his skills, and the resources and climate of the island. 

Given that resources are limited, Bill must decide how to best use them to satisfy his hierarchy of one. Food would probably come close to the top of his list. Should he spend his time simply gathering fruits and berries? Should he hunt for game? Should he clear a field and plant seeds? The answers to these questions depend on the character of the Island, its climate, its flora and fauna (are there any fruits and berries?), the extent of his skills and knowledge (does he know anything about farming?), and his preferences (he may be a vegetarian).

Opportunity Cost The concepts of constrained choice and scarcity are central to the discipline of economics. They can be applied when discussing the behavior of individuals like Bill and when analyzing the behavior of large groups of people in complex societies.

Given the scarcity of time and resources, Bill has less time to gather fruits and berries if he chooses to hunt---he trades more meat for less fruit. There is a trade-off between food and shelter, too. If Bill likes to be comfortable, he may work on building a nice place to live, but that may require giving up the food he might have produced. The best alternative that we forego when we make a choice is the opportunity cost of that choice.

Bill may occasionally decide to rest, to lie on the beach, and to enjoy the sun. In one sense, that benefit is free---he does not have to pay for the privilege. In reality, however, it does have an opportunity cost. The true cost of that leisure is the value of the other things Bill could have produced, but did not, during the time he spent on the beach.

Scarcity and Choice in an Economy of Two or More

Now suppose that another survivor of the crash, Colleen, appears on the island. Now that Bill is not alone, things are more complex, and some new decisions must be made. Bill's and Colleen's preferences about what things to produce are likely to be different. They will probably not have the same knowledge or skills. Perhaps Colleen is very good at tracking animals, and Bill has a knack for building things. How should they split the work that needs to be done? Once things are produced, they must decide how to divide them. How should their products be distributed?

The mechanism for answering these fundamental questions is clear when Bill is alone on the island. The "central plan" is his; he simply decides what he wants and what to do about it. the minute someone else appears, however, a number of decision making arrangements immediately become possible. One or the other may take charge, in which case that person will decide for both of them. The two may agree to cooperate, with each having an equal say, and come up with a joint plan or they may agree to split the planning as well as the production duties. Finally, they may go off to live alone at opposite ends of the island. Even if they live apart, however, they may take advantage of each other’s presence by specializing and trading.

Specialization, Exchange, and Comparative Advantage The idea that members of society benefit by specializing in what they do best has a long history and is one of the most important and powerful ideas in all of economics. David Ricardo, a major 19th century British economist, formalized the point precisely. According to Ricardo's theory of comparative advantage, specialization and free trade will benefit all trading parties, even when some are "absolutely" more efficient producers than others. Ricardo's basic point applies just as much to Colleen and Bill as it does to different nations.

To keep things simple, suppose that Colleen and Bill have only two tasks to accomplish each week: Gathering food to eat and cutting logs to burn. If Colleen could cut more logs than Bill in one day, and Bill could gather more nuts and berries than Colleen could, specialization would clearly lead to more total production. Both would benefit if Colleen only cut logs and Bill only gathers nuts and berries, as long as they can trade. Suppose that Bill is slow and somewhat clumsy in his nut gathering and that Colleen is better at both cutting logs and gathering food. Ricardo points out that it still pays for them to specialize and exchange. (Refer to figure 2 and the following discussion.)

FIGURE 2 Comparative Advantage and the Gains from Trade

In this figure, (a) shows the number of logs and bushels of food that Colleen and Bill can produce for every day spent at the task; (b) shows how much output they could produce in a month assuming they wanted an equal number of logs and bushels. Colleen would split her time 50/50, devoting 15 days to each task and achieving total output of 150 logs and 150 bushels of food. Bill would spend 20 days on cutting wood and 10 days on gathering food. As shown in (c) and (d), by specializing and trading, both Colleen and Bill would be better off. Going from (c) to (d), Colleen trades 100 logs to Bill in exchange for 140 bushels of food.

Suppose Colleen can cut 10 logs per day and Bill can cut only four. Also suppose Colleen can gather 10 bushels of food per day and Bill can gather only eight. A producer has an absolute advantage over another in the production of a good or service if it can produce the good or service using fewer resources, including its time. Since Colleen can cut more logs per day than Bill, we say she has an absolute advantage in the production of logs. Similarly, Colleen has an absolute advantage over Bill in the production of food. 

Thinking just about productivity and the output of food and logs, it might seem that it would pay Colleen to move to the other side of the island and be by herself. Since she is more productive in cutting logs and gathering food, would she be better off on her own? How could she benefit by hanging out with Bill and sharing what they produce?

To answer this question we must think in terms of opportunity cost. A producer has a comparative advantage over another in the production of a good or service if it can produce the good or service at a lower opportunity cost. First, think about Bill. He can produce 8 bushels of food per day or he can cut four logs. To get 8 additional bushels of food, he must give up cutting 4 logs. Thus, for Bill the opportunity cost of 8 bushels of food is 4 logs. Think next about Colleen. She can produce 10 bushels of food per day or she can cut 10 logs. She thus gives up 1 log for each additional bushel, and so for Colleen the opportunity cost of 8 bushels of food is 8 logs. Bill has a comparative advantage over Colleen in the production of food because he gives up only 4 logs for an additional 8 bushels whereas Colleen gives up 8 logs.

Think now about what Colleen must give up in terms of food to get 10 logs. To produce 10 logs she must work a whole day. If she spends a day cutting 10 logs she gives up a day of gathering 10 bushels of food. Thus for Colleen the opportunity cost of 10 logs is 10 bushels of food. What must Bill give up to get 10 logs? To produce 4 logs he must work a day. For each day he cuts logs he gives up eight bushels of food. He thus gives up two bushels of food for each log, and so for Bill the opportunity cost of 10 logs is 20 bushels of food. Colleen has a comparative advantage over Bill in the production of logs since she gives up only 10 bushels of food for an additional 10 logs whereas Bill gives up 20 bushels.

Ricardo then argues that two parties can benefit from specialization and trade even if one party has an absolute advantage in the production of both goods. Suppose Colleen and Bill both want equal numbers of logs and bushels of food. If Colleen goes off on her own, in a 30-day month she can produce 150 logs and 150 bushels, devoting 15 days to each task. For Bill to produce equal numbers of logs and bushels on his own requires that he spend 10 days on food and 20 days on logs. This yields 80 bushels of food (10 days * 8 bushels per day) and 80 logs (20 days * 4 logs per day). Between the two, they produce 230 logs and 230 bushels of food.

Let's see if specialization and trade can work. If Bill spends all his time on food, he produces 240 bushels in a month (30 days * 8 bushels per day). If Colleen spends three days on food and 27 days on logs, she produces 30 bushels of food (3 days * 10 bushels per day) and 270 logs (27 days * 10 logs per day). Between the two, they produce 270 logs and 270 bushels of food, which is more than the 230 logs and 230 bushels they produced when not specializing. Thus, by specializing in the production of the good in which they enjoyed a comparative advantage, there is more of both goods.

Even if Colleen were to live at another place on the island she could specialize, producing 30 bushels of food and 270 logs and then trade 100 of her logs to Bill for 140 bushels of food. This would leave her with 170 logs and 170 bushels of food, which is more than the 150 of each she could produce on her own. Bill would specialize completely on food, producing 240 bushels. Trading 140 bushels of food to Colleen for 100 leaves him with 100 of each, which is more than the 80 of each he could produce on his own.

The degree of specialization in modern industrial societies is breathtaking. Let your mind wander over the range of products and services available or under development today. As knowledge expands, specialization becomes a necessity. This is true not only for scientists and doctors but also in every career from tree surgeons to divorce lawyers to webmasters. Understanding specialization and trade will help you to explain much of what goes on in today's global economy.

Weighing Present and Expected Future Costs and Benefits Very often we find ourselves weighing benefits available today against benefits available tomorrow. Here too the notion of opportunity cost is helpful.

While alone on the island, Bill had to choose between cultivating a field and just gathering wild nuts and berries. Gathering nuts and berries provides food now; gathering seeds and clearing a field for planting will yield food tomorrow, if all goes well. Using today's time to farm may well be worth the effort if doing so will yield more food than Bill would otherwise have in the future. By planting, Bill is trading present value for future values.

The simplest example of trading present for future benefits is the act of saving. When I put income aside today for use in the future, I give up some things that I could have had today in exchange for something tomorrow. Because nothing is certain, some judgment about future events and expected values must be made. What will my income be in 10 years? How long am I likely to live?

Capital Goods and Consumer Goods A society trades present for expected future benefits when it devotes a portion of its resources to research and development or to investment in capital. Capital in its broadest definition is anything that has already been produced that will be used to produce other valuable goods or services over time.

Building capital means trading present benefits for future ones. Bill and Colleen might trade at Gathering berries or lying in the sun for cutting logs to build a nicer house in the future. In a modern Society, resources used to produce capital goods could have been used to produce consumer goods---that is, goods for present consumption. Heavy industrial machinery does not directly satisfy the wants of anyone, but producing it requires resources that could instead have gone into producing things that do satisfy wants directly---food, clothing, toys, or golf clubs.

Capital is everywhere. A road is capital. Once it is built, we can drive on it or transport goods and services over it for many years to come. A house is also capital. Before a new manufacturing firm can start up, it must put some capital in place. The buildings, equipment and inventories that it uses comprise its capital. As it contributes to the production process, this capital yields valuable services through time. 

Much the enormous amount of capital---buildings, factories, housing, cars, trucks, telephone lines, and so forth---was put in place by previous generations, yet it continues to provide valuable services today; it is part of this generation's endowment of resources. To build every building, every road, every factory, every house, and every car or truck, society must forgo using resources to produce consumer goods today.

The process of using resources to produce new capital is called investment. (In everyday language, the term investment often refers to the act of buying a share of stock or a bond, as in "I invested in some treasury bonds." In economics, however, investment always refers to the creation of capital: the purchase or putting in place of buildings, equipment, roads, houses, and the like.) A wise investment in capital is one that yields future benefits that are more valuable than the present cost. When you spend money for a house, for example, presumably you value its future benefits. That is, you expect to gain more from living in it than you would from the things you can buy today with the same money.

Because resources are scarce, the opportunity cost of every investment in capital is forgone present consumption. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 24-28*

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