As human beings, what do we want and need? We certainly all need food, water, and shelter.
And our wants may range from wealth to adventure to entertainment. These wants
and needs are without bounds, but even though we have endless wants and needs, everything runs out.
Food gets eaten. Money gets spent. And the Netflix show you’re currently binging has a final season.
The things that fulfill our wants and needs are finite in nature. As we learned in the previous
tutorial, this idea is called scarcity, and it drives everything in economics. We make personal
choices, business choices, and collective choices differently, but we all do so based on scarcity.
We can’t do everything or have everything, so we must weigh our options and make the best choice
for ourselves that we can, based on our situation. All choices involve trade-offs. A trade-off is the
act of giving up one benefit in order to gain another potentially greater benefit.
For example, you are benefiting from watching this tutorial right now,
but you chose to watch it because the perceived benefit of watching this tutorial outweighs
other things that also could benefit you. Right now, you could instead be playing video games,
or fishing, or rollerblading, or watching Netflix, or building birdhouses. All of those
things could benefit you. But watching this tutorial benefits you more at this moment.
When a restaurant makes a choice to pay its servers higher wages, it may have to be at the
cost of spending money on advertising, or buying new appliances, or even paying its custodians
higher wages. When a government makes the choice to spend more money on combat drones and bombs,
it may have to be at the cost of spending more money on education, healthcare, or fixing roads.
Whenever we make a choice, there is always an opportunity cost. Opportunity cost is the next
best thing we give up by making that choice. It’s essentially the most desirable alternate choice,
something which is useful to identify when making decisions because it reminds us to compare the
value associated with various options. Going back to our earlier example of you choosing
to watch this tutorial, say you were to rank your alternate choices of playing video games,
fishing, rollerblading, watching Netflix, and building birdhouses in this order.
Remember, you chose to watch this video, so these are your next best choices. But your opportunity
cost is watching Netflix, since that is your very next best choice, and you are giving up
the opportunity to watch Netflix at this moment by choosing to watch this tutorial instead.
Let’s look at another example. Every night, we make a choice regarding when to go to sleep.
Say you normally get eight hours of sleep, but you only get five hours of sleep one
night since you stayed up late studying three hours for an economics test. Your alternatives
were eight hours of sleep and no studying, seven hours of sleep and one hour of studying,
or six hours of sleep and two hours of studying. What is your opportunity cost? Well,
it depends on who you are, but if you value studying over sleep you might rank the options
in this way, with the options becoming less desirable as the increment of study decreases.
According to this ranking, the opportunity cost associated with an extra three hours of studying
rather than two is the additional hour of sleep you gave up.
This ranking of choices leads to the idea of something called thinking at the margin.
Thinking at the margin has to do with making decisions based on small changes in the allocation
of resources. So one way of framing this concept involves deciding how much more or how much less
to do something, with all else held equal. Looking at the sleep versus studying example,
you’d be thinking at the margin if you thought about answering the question: What is the proper
balance of sleeping versus studying in order to best prepare for the test? The process of
making a decision like this is sometimes called a cost/benefit analysis. To make rational choices,
we weigh marginal costs versus marginal benefits. These are terms that refer to either the cost
added or benefit gained that is associated with one additional unit of a good or service.
In this particular case we could consider the marginal cost of studying to be how much more
tired you are the next morning due to having slept one hour less. Perhaps a lot more tired,
perhaps it’s negligible. And the marginal benefit of studying would be the information
you learn or retain from one additional hour of studying. Maybe it doesn’t help much,
and perhaps that one hour raises your grade from a B to an A. If we could rigidly quantify the cost
of sleeping less as well as the benefit of studying more, we could hypothetically arrive
at a firm answer to this particular predicament. The average adult makes around 35,000 choices
per day. Most of these choices are automatic, but the more important the choice, the more
effort that typically goes into the cost/benefit analysis. Recognizing and weighing the trade-offs,
thinking at the margin, and considering the opportunity cost of every choice is
a mental exercise that can help make the big decisions in life a little easier.
And now we understand the concepts of scarcity, trade-offs, and cost/benefit analysis.