Economic Principles 101: Opportunity Costs
Economics is all about tradeoffs. Whenever you make a decision, there are always tradeoffs associated with that choice. That's because there is only a fixed number of resources such as land, labor, money, or time that exist at any given moment.
For example, if you buy a car, the money spent on the car cannot also be used for something else, say the purchase of shares of stock. Conversely, if you choose to buy shares of stock, you must give up the car. It's one or the other. If you choose to spend time at a movie, that time cannot also be spent reading a book. On a bigger scale, if the United States decides to build a fighter plane, it is simultaneously giving up some cars, bridges, roads, or other assets that could have been produced instead.
The concept of opportunity costs seems straightforward, yet it is the cause of many economic fallacies. It is imperative not to forget that there is always some sort of tradeoff involved with every decision. For example, here in South Florida you will often hear people talk about the positive economic benefits of hurricanes. Hurricanes provide lots of construction workers with new jobs. Bulldozers, cement, bricks, lumber, drywall, nails, drills and other necessary equipment is purchased or leased and seen on every street corner. And don’t forget about the factory employees working overtime to replenish the inventory depleted by the surge in the South Florida demand. Lots of people are working; lots of money changing hands. It’s hard to believe there is no benefit to a high-quality, category five sweeping through the state.
But the real damage is never seen, which is why it's easy to overlook. Had the hurricane not destroyed a community, those same workers, bulldozers, bricks and mortar and other resources could have been used to build something the community did not have before, say a much-needed bridge, road, or school. The reality is, after the homes are rebuilt, the community is left with the same homes it had before. It is no better off than before the hurricane. All the time, materials, and labor spent did not put the community ahead; it just brought it back to even.
While it is true that some groups of people (construction workers, for example) will benefit from such disasters, there is an enormous opportunity cost for the rest of the state. Overall, hurricanes create net losses. If it weren’t true, we could all be made better off by destroying our homes every year and rebuilding them. It is the concept of opportunity costs that lead to the economic expression, "There's no such thing as a free lunch." The lunch may be free to you, but that doesn't mean it came without costs.
Every decision has a cost. The highest valued product or service (or “opportunity”) foregone is called the opportunity cost. In the previous example, if the hurricane-struck community would have built a bridge had the hurricane not hit then the bridge is the opportunity cost of rebuilding the homes. The opportunity cost is the product or service that never comes into being due to another decision being made.
As another example, most people consider the course you are reading right now “free.” When people say something is free, they usually mean there is no required out-of-pocket expense. However, that doesn’t mean it’s truly free from costs. If you were going to see a movie tonight but elected to read this course instead then the movie is the opportunity cost to you for taking the course. By reading this material, there is one less movie ticket that the theater owner will sell tonight.
Because it’s easy to overlook products or services that are never created, it is very easy to forget about opportunity costs. But they are very real and must be taken into account. As you go through this course, remember the concept of opportunity costs. You will find later in the course there are significant economic tradeoffs (opportunity costs) when the Federal Reserve alters the supply of money.
Economic Principles 101: Supply And Demand
Before you can fully understand many of the economic topics we'll be talking about, it is necessary to cover our third and final economic principle: supply and demand. The principles of supply and demand are invaluable tools for understanding the behavior of consumers and producers and their effect on prices. Since we will be talking a great deal about prices and how they are determined, it is necessary to understand the two economic forces that create them.
People have vastly different thoughts on prices and how they come about. How many times have you heard people complain that tickets to professional sporting events are "outrageously" priced and that it's unfair that "they" charge that much for them? People who make these comments believe that the seller is solely responsible for setting prices; they never even consider the demand side. On the other hand, there are people who believe that buyers are strictly responsible for determining the prices of some products. Why are American cars cheaper than the European cars? This group of people will tell you it's because nobody wants to buy the American cars compared to the European cars; they completely neglect to mention anything about the supply.
People have vastly different thoughts on prices and how they come about. How many times have you heard people complain that tickets to professional sporting events are "outrageously" priced and that it's unfair that "they" charge that much for them? People who make these comments believe that the seller is solely responsible for setting prices; they never even consider the demand side. On the other hand, there are people who believe that buyers are strictly responsible for determining the prices of some products. Why are American cars cheaper than the European cars? This group of people will tell you it's because nobody wants to buy the American cars compared to the European cars; they completely neglect to mention anything about the supply.
The supply of anything is simply the physical number of items that are available for sale at a specific price while the demand for that item is a perceived value that exists in the minds of consumers. Of course, this perception must be backed up by the willingness and ability to pay that price. If General Motors invents a high-performance solar-powered sports car that comes with a million mile warranty, you may think the demand for it would be great. However, if it carries a multi-million dollar price tag, the demand may be near zero, as far as economists are concerned.
The fact is, the price of any good is strictly determined by the supply and the demand for it. It is both forces taken together and not simply one or the other. If only “supply” determined price, homes in New York City would be cheaper than homes in Monkey’s Eyebrow, KY since there are far more homes in New York City. Similarly, if only “demand” determined price, then water should be infinitely expensive since everybody must have it for survival.
The reason professional sporting events are "outrageously" priced is because we place an equally high demand on them. On October 19, 2007, CNNMoney.com published an article stating that Alex Rodriguez, the New York Yankees’ superstar third baseman, is about to sign a new ten-year contract valued between $300 and $400 million. Why would any team think about paying that much money? Because millions of fans will pay hundreds of dollars per ticket. It’s the forces of supply and demand together that create prices, not one or the other. In order to understand these forces better, let’s take a closer look at the individual laws that govern them.