Scarcity and Opportunity Cost 21:01
Baetjer explains scarcity, the problem that any given good of finite supply can only ever be put to some of the many ends for which we might use it, and opportunity cost, the concept that taking one option costs us the benefit we would have gotten from taking the next-best option instead.
Howard Baetjer: Continuing now in this second lecture on basic concepts of economics, there are three main topics in this lecture. The first is scarcity, what’s meant by scarcity. Next is the inevitable consequence of scarcity, which is the need to ration or somehow decide who’s going to get the scare [00:00:30] goods. The third concept we’ll talk about is the very important economic concept of opportunity cost.
Let’s begin with scarcity. The definition of scarcity, what we mean by scarcity is that there is less of a good freely available from nature than people would like. There’s less of a good freely available from nature than people would like. Can you think of any goods [00:01:00] that are not scare? That is any goods that there’s enough freely available from nature to satisfy all people’s wants for it.
Howard Baetjer: Air is the only one I can think of.
Howard Baetjer: Sunshine, good, okay, yeah, sunshine.
Howard Baetjer: [00:01:30] They’re not a good. They’re a bad. Sometimes my students will say water, clearly meaning purified water, fresh water to drink, and there’s not enough of that freely available from nature to satisfy everyone’s wants. That’s what we mean by scarcity. Now scarcity is not [00:02:00] rareness. Things can be plentiful, but still scarce. Things can be rare, but not scarce. For example, are cars scarce?
Howard Baetjer: Sure they are. Are they rare?
Howard Baetjer: No, there are plenty of them. But they’re scarce because does everyone who wants a car have one?
Student: No, as every 16 year old will tell you.
Howard Baetjer: As every 16 year old will tell you. Cars are [00:02:30] not rare, but they’re scarce because there’s not enough to go around. I think there are very few goods you can come up with that are not scarce. Almost everything that we care about and we value is scarce. Sunshine, air, and of course there are certain situations such as on Apollo 13 where air was scarce also, but for most of us … Indeed in certain areas of the world now, [00:03:00] fresh air, clean air, is scarce. People have to go to some effort to clean the air, effort and expense to clean the air around them.
That’s scarcity. If it’s hard for you to think of cars as scarce, then it sometimes is helpful to think of the raw materials that are needed to produce cars as being scarce. When we take our thinking back one more step to [00:03:30] the raw materials needed to produce all the many goods and services that we want, then it becomes pretty clear that almost everything is scarce because there’s not enough of the different metals and chemicals and so on to make everything that we want. Scarcity is a fundamental fact of life.
Thomas Sowell and is wonderful book, Basic Economics, emphasizes this, that what economics is about is how do we decide how to use [00:04:00] these scarce resources which have alternative uses. Should we use metal for a car or for a lawnmower or for a structure of some sort? Because the resources are scarce, we need to figure out how best to use them.
A lot of economics is about that. Scarcity is a fundamental fact of nature.
Second point, because scarcity is all around us, because scarcity is a fact [00:04:30] of life we have to deal with, we need somehow to figure out who’s going to get the available quantities of different goods. The term that the textbooks use on that is rationing. If goods are scarce, there’s not enough to satisfy everyone’s wants. Well, we have to ration the available supply amongst the people and the different uses for it. How do we decide who gets additional quantities of something? That’s rationing. A lot of economics is about [00:05:00] that too.
What are some methods of rationing scarce goods that you guys can think of? Let’s have a little bit of fun with it. Suppose we had a box of donuts here and there weren’t enough to go around. What are some of the ways we could use to determine who gets the available donuts?
Howard Baetjer: Dibs?
Student: It’s where you call what you get.
Howard Baetjer: Okay, yeah, you call out first dibs. All right, we could use dibs. What else?
Student: Limiting how many people can take. It goes around, you each take one [00:05:30] until …
Howard Baetjer: But how would you … Oh I see, limit the number people could take. Suppose there’s not enough donuts in the box for everyone.
Howard Baetjer: We could use price, see who’s willing and able to pay the available price. That’s the method that we use in economics. But I wanted to get to that a little bit later. We could have arm wrestling. We could have a beauty contest. We could fight for it. By the way, that’s a means of rationing scarce goods that human beings have used for a long time. We fight for things. [00:06:00] Rationing according to price, willingness and ability to pay, is the main way of rationing scarce goods in a market economy. What are some advantages and disadvantages? Let’s start with disadvantages of rationing according to price, so that the available goods, scarce goods, goes to those who are willing and able to pay the market price. What’s unfortunate about that?
Student: It precludes people who are either [00:06:30] unwilling or unable to pay.
Howard Baetjer: Yeah, well let’s focus on unable. Let’s suppose you have people who are very willing, indeed eager to pay, but they’re unable to pay. That’s a downside of rationing according to willingness and ability to pay, downside of rationing according to price because some people can’t pay it and that can be a very serious problem. There are ways around that of course. One of them is generosity, looking out for our fellow men and women. [00:07:00] Another way is to establish the institutions that will allow people to create wealth so they’ll be able to afford it, become able to pay. But there’s a fundamentally important advantage to rationing according to willingness to pay. What’s that?
Student: It’s efficient.
Howard Baetjer: It’s efficient, but that’s sort of jargon. Let’s go a little deeper. What’s the advantage of rationing goods according to willingness to pay? [00:07:30] Take the donut example for example. What would make sense about having the donuts available go to those who are willing to pay the most?
Student: It’s indicative of who values them the highest.
Howard Baetjer: Well said. It’s indicative of who values them the highest. There’s a tendency at least, remembering that sometimes people are very willing but unable to pay. Leaving that aside, those who are willing to pay the most generally are those who put the highest value on something. It’s a way of getting the scarce goods to those [00:08:00] who want them the most, who can make the best use of them. Rationing according to willingness to pay has that great advantage.
All right, going on then directly to the next main concept, and these main concepts are in no particular order, the concept of opportunity cost. Let’s approach it this way. If you weren’t here right now, what would you be doing instead? What would you have chosen to do [00:08:30] instead of coming here?
Student: Go on a walk or read or do something.
Howard Baetjer: Go on a walk or read or do something. How about you?
Student: Work, probably.
Howard Baetjer: You have some other work that’s probably not getting done right now.
Howard Baetjer: What do you suppose is the answer for my students most of the time? If you weren’t in class now, what would you be doing?
Howard Baetjer: Sleep, all the time. It’s as if they’re sleep deprived. This [00:09:00] example gets at the meaning of opportunity cost. The next best thing that a person might have done instead of whatever she chose to do is the opportunity cost. Actually, I’m going to refine that definition a little bit, but let’s start it that way. Opportunity cost is what you give up by taking an action. A better definition, or a subtlety to the definition of opportunity cost is to think of it not as the next best opportunity [00:09:30] forgone, but as the value to you of the next best opportunity foregone. For reasons we’ll see, it’s going to be much more useful in our economic thinking to think of the value of the opportunity foregone rather than as the opportunity itself. We’ll get to that.
Next main point with respect to opportunity cost is that actions have costs. It’s best to think of actions as having costs, not things. Suppose [00:10:00] you pay $2 for a bottle of water. What cost you was purchasing the bottle of water, not the bottle of water itself. In other words, it’s a little bit imprecise to say the cost of this bottle of water was $2. No, how do you want to say it a little more precisely? It’s not the cost of this bottle was $2. The cost you of buying it because you otherwise would have had the $2 left to devote to something else. [00:10:30] Think of actions as having costs rather than things. This will fit with the fact that different people have different values. Because costs are values, the value of the next best opportunity foregone, and because values are subjective, that means that costs are subjective also. The same kind of action will have a different cost to different people. Take for example studying on Sunday [00:11:00] afternoon in the fall. Can you think of why that might have, in America at least, why that might have very different costs to different people? What would be one of the main costs of studying on Sunday afternoon in the fall?
Howard Baetjer: Football. The opportunity cost, the alternative foregone is watching a football game, but some people don’t care about football, so the cost of studying on Sunday afternoon to that person would be less than the cost of studying on Sunday afternoon to [00:11:30] someone who loves football. People value things differently. That means the costs are going to be different. To get more into an example, we’ll develop a little bit more the cost of growing a bushel of wheat will differ for different farmers. Think why that might be. Why might one farmer have a different cost of growing a bushel of wheat than another?
Student: Land has different uses and maybe he could have grown corn.
Howard Baetjer: Land has different [00:12:00] uses. He might have grown corn instead. If he grows wheat he can’t grow corn. If the value of the corn he could grow on that land was very high, then he has a high opportunity cost of growing a bushel of wheat. But, another farmer might have land that’s really only good for wheat. I don’t know enough about farming to know if that’s even sensible, but if that’s the case, then the opportunity cost would be different. Let’s take a third farmer who has poor land. In order [00:12:30] to grow a bushel of wheat, he may need to use fertilizer and irrigation that has an alternative use. He must pay for the fertilizer, pay for the irrigation. He could have spent that money on something else instead. The cost will differ for different people.
Every action has a cost. The main point I want you to think of here is that there’s nothing free. Often when we teach about opportunity cost, we [00:13:00] use that expression from Robert Heinlein’s, The Moon is a Harsh Mistress, [inaudible 00:13:06] there ain’t no such thing as a free lunch. Resources that are used for one thing cannot be used for something else. NFL, my friend Jim Dorn at Cato, says to his students, there’s no free lunch. If time is used for one thing, it can’t be used for something else. If resources are used for one thing, they can’t be used for something else. Every action has a cost.
[00:13:30] Finally, cost and price are different. Cost and price are different. For example, and here’s a loaded question for you. It’s meant to throw you off and get you to focus here. What’s the cost of a car?
Student: Raw materials and labor.
Howard Baetjer: Pardon me.
Student: Raw materials and labor.
Howard Baetjer: Raw materials and labor. That’s good. That’s what I’m thinking about. That’s one thing I’m thinking about. That would indicate the cost [00:14:00] of producing a car. The cost of producing a car is the next best uses of the raw materials, the labor, the factory space, everything that goes in to producing the car. But how might you answer it differently? What’s the cost of a car?
Student: The cost of the capital to produce a car.
Howard Baetjer: Well, the capital is going to be part of it. I put those two together, but think about …
Student: Labor required you to acquire the money.
Howard Baetjer: I’m thinking about the …
Student: [inaudible 00:14:28] opportunity cost.
Howard Baetjer: I’m [00:14:30] thinking about the cost of buying a car.
Student: Oh, okay.
Howard Baetjer: To the producer, producing a car is different from buying a car. It’s really a meaningless question that I asked you. What’s the cost of a car? Well, to whom? In the same way you should say what’s the value, well, the value to whom because costs are values of foregone alternatives. If I say what’s the cost of something, you should say cost to whom. The cost to the car maker is the next best thing, maybe [00:15:00] another model of a car they could have produced with the same factory. But what might be the cost to the buyer of a car?
Student: Opportunity cost.
Howard Baetjer: Well, yes. What might be the opportunity cost to the buyer of a car. Have any of you bought your own first car yet? Do any of you own a car? When you do, suppose you buy a car, what’s the opportunity cost?
Student: Not buying something else. [crosstalk 00:15:22]
Howard Baetjer: Exactly, all the something elses you could have bought. The act of buying the car means all that money is tied up [00:15:30] in the car and you can’t use it to go to Ravens football games or to buy books or upgrade your internet connection, whatever it might be. The next best opportunity foregone is the opportunity cost. Cost and price are different then. The cost of producing the car to the car factory, the car manufacturer, is going to be different from the price it charges. [00:16:00] They’re hoping that which will be larger?
Student: The price.
Howard Baetjer: They want the price to be larger than the money cost of producing the car. But when you buy the car presumably it means that the value to you is higher than the price that you pay. The cost to you of buying a car, the next best things you forego, must be less than the price you [00:16:30] pay because you’re only willing to pay if the next best things are worth less to you.
Cost and price are different. Keep those in mind as we go on. That’s the end of the second lecture pending any questions you have.
Student: It seems that when you leave transactions purely to market prices, there’s a level of inequity [00:17:00] that results. How do you solve for inequity even if the transaction is efficient?
Howard Baetjer: Okay, let me see if I can rephrase it. The rationing by willingness and ability to pay can really look unfair to us in many cases because people with an urgent need don’t have the ability to pay for what they need. Because of that, [00:17:30] people want to override the market process. They want to find a different way of allocating, of rationing scarce goods. I’d say first of all I would want to concede first of all that there is something unfair, in a sense of unfair there, there’s something unfair. Certainly there’s something regrettable about that, that there are going to be people who have an urgent need for [00:18:00] things and they can’t afford them. That’s too bad. It’s to be regretted. It’s part in parcel of the market system, but I don’t think that’s enough of a reason to do things differently because in an imperfect world, there’s no alternative that doesn’t have more problems.
Let’s get to why. In subsequent lectures, we’re going to get to why. The [00:18:30] prices that arise out of market interplay are extremely important for maintaining social coordination, for signaling people what to do to produce abundantly. There just won’t be anywhere near as much to go around if we don’t use market prices, so we rely on this market system to produce the prices and the profit and loss signals that are so important to us. The benefits of that are significant [00:19:00] enough to justify the sad fact that some people aren’t going to be able to afford what they need. But I would add to that also.
You used the word transactions. You said the only transactions in a market are on a money basis. That’s not really true. It’s also a transaction when you who have been well educated and produced well and earned money make a donation to a soup kitchen or to a scholarship fund to help people who can’t afford good schooling. [00:19:30] That’s another kind of transaction. It’s not a market transaction. It’s a voluntary transaction. There are all these other ways of doing things, mutual aid societies, insurance, donating to the church, donating to the United Way, to the soup kitchens. There are lots of other ways human beings have for taking care of those that they see are in need or want through no fault of [00:20:00] their own. We’re going to be much better able to take care of them if we’re embedded in a market system where the basic allocation system is by willingness and ability to pay. There will be more for everyone in that kind of a system. Then it’s up to the non-commercial instincts, the non-commercial, the loving impulses that we have to take care of people who are deserving and don’t have what they need. [00:20:30] Better to take care of that problem that some people don’t have enough to buy what they need, better to take care of that out of voluntary generosity in a market system than to interfere with the market system. I’ll [00:21:00] leave it at that.