A scenario
Let's say you have $1,500 available. You could buy 100 CDs, a DVD player and 30 DVDs, or a new, more powerful computer to replace that 486DX33 that's served you so well the past decade. It's unlikely that you'll blow it all on CDs, although some music aficionados would do just that. In our example, however, you opt for the computer because the value you receive from this computer exceeds that which 100 CDs might bring you in usability and pleasure.
On your way to the store to buy your computer, your engine throws a rod. Instantly, you're faced with another economic decision. The computer would be very useful, but you need the car to get to work -- continued employment is more important than whatever you could have done with the computer.
That replacement car engine had an opportunity cost of "one computer". Economics defines the opportunity cost of anything as "the value of the next best thing foregone". The computer had an opportunity cost of 100 CDs or a DVD player and 30 DVDs (if the two were equal in value to you). You were willing to give those up for the computer. The car didn't have an opportunity cost of 100 CDs though because you'd given them up in your choice of the computer.
Cost
This leads us into the concept of monetary prices, of which there are two: absolute prices, or a price defined in a unit such as Dollars or Euros or Yen, and relative prices, or the price of goods in terms of each other. In our example above, the absolute price of each choice was $1500; the relative price of a computer was one car engine or 100 CDs.
- Prices give information
They let you know about seller's costs and buyer's wants. If you go to the supermarket, you'll see potatoes are 1/4 of the price of French fries. The price reflects -- among other things -- the additional costs of producing fries from those potatoes and the additional amount people are prepared to pay so that they don't have to make the fries themselves.
- Prices provide incentives.
A bartender isn't thrilled with wiping and cleaning all the time, but he's being paid to do it and accedes. Very few people would perform all of the tasks expected of them in the course of their work without the incentive of income.
- Prices work as rationing devices.
Those goods which are scarce will carry a higher price, limiting their purchase to those who are willing and able to sacrifice more to obtain them. Remember that purchasing one item also means not purchasing another.
Efficiency
In economic terms, efficiency is the result of producing a combination of outputs with the maximum possible value given limited resources. This can be at a personal or societal level. There are three basic categories of efficiency answering the questions "What should we produce?", "How should we produce it?" and "Who gets it?" Unfortunately, it's a lot easier to define inefficiency than efficiency. It's also easier to discuss in terms of a country rather than a single person, but the logic and processes behind the decisions made for one or one billion are the same.
Value
Economics is about cost and value and efficiency, not necessarily money. We usually discuss things in terms of money though because that's the most common method to express value as well as the most concrete. Personal satisfaction is another important measure, but one which, like mojo and karma, is much harder to define, especially in discreet amounts.
You don't believe me? You just got a call from a friend who managed to get you a front row ticket to see your most favouritest band in the whole wide world and got you a backstage pass. On the day of the concert, your old best friend from school who's been gone for what seems like forever and who you've been trying to get hold of for months calls you on the phone and says he's in town for the night before heading off on a midnight flight to Antarctica where he'll be stationed as part of the Penguin Patrol for the next two years. You have to make a decision. Explaining why you'd buy the computer, CDs or car engine in the opening scenario is a lot easier than trying to quantify a decision based on desire and satisfaction. You do it all the time for yourself, but you rarely have to explain your decision to someone else.
We live in a world of scarcity and limits. There are limited natural resources, limited amounts labour, a limited amount of time. Our desires always exceed these limitations and we are forced to make choices. If you go to an ice cream shop which offers 30 different flavours, you have to make a choice. We can make this more interesting by saying the store is having an anniversary blowout and that the ice cream is free and unlimited. You still have to make a choice, because even though the goods are unlimited, your time and capacity to enjoy them aren't. While you might like a scoop of each flavour, your capacity to eat ice cream is limited. You can't eat 30 scoops, so you choose those that bring you the most pleasure.
Economics is forced to make generalisations. A fundamental one, defined by Adam Smith, is that people act purposefully and rationally to maximise their pleasure given limited time, resources, information and budgets. There are countless examples of irrational decisions but, as a blanket rule, this statement is correct.
Economics is concerned with efficiency, which is achieved for a society when, given its limited resources, the highest output with the highest value is attained. Seen from the allocative point of view, an efficient economy produces what people want at the lowest possible price. When an economy is purely efficient, it's impossible for one person to gain without another losing. This ideal point is very close to the basic mercantilist economic idea1, though only in the results rather than the belief in finite capital.
In moving towards efficiency, new allocation makes at least some people better off without making others worse off. Let's say I have a pile of yacht wax I got on sale. If I go to the eye doctor and he says I need a monocle, I could call Rusty and trade him some of my yacht wax for some of his excess monocle polish. If he trades, it's made at least one of us better off without hurting the other. The reason I know this is that I'm willing to make the trade, so I value a little monocle polish higher than the yacht wax I'm willing to trade. If Rusty accepts the terms, then either the value of wax and polish to him are even or my yacht wax is more valuable to him more than the polish. If he accepts the trade, he may benefit and I know I do. This is a move toward (allocative) efficiency.
Guns & Butter: Determining Efficiency
Though I wrote of pickles and toilet paper in an example above, the most common items used to explain production possibilities are guns and butter.
Again, while the principles are applicable to even a personal level, it's easier to discuss them as they apply to a society. In order to explain the concept, we'll act like typical economists and build a hypothetical model: our hypothetical country is called Kehfyvistan and they produce two products, guns and butter2.
Through analysis, we've determined that Kehfyvistan can produce guns and butter in the amounts shown on this graph, known as the Production Possibilities Frontier, or PPF:
Giving up 1000 cases of guns allows Kehfyvistan to make 1000 tons butter. Kehfyvistan can produce efficiently anywhere on the red line from points A through F.
Point X could also be a production target, but being under the curve (a straight line is also a curve with an arc of 0), it's inefficient. It's possible to produce more guns or butter or both.
Kehfyvistan cannot produce at the level of Point Y however, because more resources (labor, materials, land) would be needed than Kehfyvistan has.
Things aren't this simple, though. They rarely are. A real PPF curve looks more like this:
While between points D and E the trade-off is pretty much equal, it's drastic from points A to B and from G to J. Why?
Specialisation.
Many who work in the guns field could just as easily work in the Kehfyvistani butter industry. The sales force, mailroom workers, secretaries, drivers, and other such workers can easily shift from one industry. Land used for obtaining raw materials like ore and wood for stocks as well as for manufacturing could be turned into grazing land for more cows.
However, once all the easily shifted resources have been reallocated, the law of diminishing returns rears its head. Keep adding pasture land and you end up using less and less suitable land, like quarries and wooded areas. Keep taking people and you start taking specialists. A highly qualified machinist or chemist hasn't been trained in buttermaking tasks. A sharpshooter is pretty useless in quality testing the butter. It may be possible to put these people to work in some capacity, but it's inefficient.
Whereas the opportunity cost of increasing butter production at the cost of guns at points D and E is 1000 tons for 1000 cases, that cost increases as we move to point F, where we only increase our butter output by 500 tons at an opportunity cost of 1000 cases of guns. If we continue shifting our resources to a butter-only economy and go to point G, we lose another 1000 cases of guns for only 200 tons of butter. Butter's getting pretty expensive; a ton of butter is now costing us 5 cases of guns. If we move to H, we lose another 500 cases of guns for only 40 tons of butter. The marginal cost of butter just tripled.
The opportunity cost of those 10 tons of butter is another 500 cases of guns, hardly a 1:1 trade-off anymore, but maybe it's still worthwhile...
In the next column, we'll pick up with the PPF and go into the reasons for -- and benefits of -- trade.
1 We'll save the discussion of various economic systems, including mercantilist, classicist, command, capitalist, neo-classicist and others, for a later column.
2 Yes, perhaps Kehfyvistan's products should be "crapfloods and occasional gems" but "guns and butter" is easier to explain.
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