Econ 101
This post comes under the sub-section Econ 101. Under Econ 101 I try to cover some basic economics concepts that will come handy in public policy discussions. We won't cover economic theory exhaustively, there are many textbooks that can do this better. We will be focussed on developing an economic way of looking at the world.
Everyday Trade-offs
Let's start with a hypothetical story. Neha and Priya are good friends. Neha works for a policy think-tank and earns ₹40,000 a month. Priya works as a tutor for GRE students, earning ₹20,000 a month. Both of them decide to do Masters in Public Policy and get admitted to the same college. Neha bags a full scholarship offer from the college, because of her background in policy. But Priya was only offered a 50% scholarship, which meant she had to pay a tuition fee of ₹10,000 a month.
At first glance, it looks like this college degree costs more for Priya than Neha. But a basic economic understanding about trade-offs can make you think otherwise.
But first, what are trade-offs?
Simply put, a trade-off happens when you have to give up one thing for another. We make trade-offs every day, in every choice we make. When you made a choice to read this article right now, you had to give up something else you could have done with your time. That's a trade-off. When you spend money on, let’s say a phone, you are trading away the opportunity to spend that money on something else.
Trade-offs exist because resources are scarce or limited. Scarcity means we don’t have the resources to fulfil all our wants. Time, natural resources, money etc. are limited. We can't have or do everything.
Opportunity Cost
In economics, the value of what you give up when you make a choice is what is called as opportunity cost. The opportunity cost of a choice is the value of the opportunities lost. If there are trade-offs in every choice we make, then every choice also has an opportunity cost associated with it.
In our previous example, both Neha and Priya are giving up their jobs to study in college. The salaries that they would have earned, if they were not in college, is the opportunity cost of studying in college. For Neha it is ₹40,000 and for Priya it is ₹20,000 a month. But for Priya, to study in this college she has to pay a fee of Rs. ₹10,000 a month as well. So if we consider opportunity cost also into their costs, Neha's total cost of studying in that college is ₹40,000 and for Priya it is ₹30,000 (20,000 + 10,000). (Room, food etc. is not a cost of college if you would have to pay for it whether you go to college or not).
The cost incurred for this college degree is more on Neha, than Priya, although it didn't look like that at first.
Specialisation
Always keeping in mind that everything has a cost is one of the keys to thinking like an economist. One such area where opportunity cost finds an important application is when you want to do something by yourself instead of hiring someone.
Doing it yourself is fun, and cheap. But the cost of doing it yourself is the value of what you could have done in that time. What if a person tried to be self-sufficient? She grew her own vegetables, built her home by herself, stitched her clothes. But can she make the farming and construction tools too? Does she have enough time to learn and exercise these skills? Who will teach her these skills? In reality, anything close to genuine self-sufficiency is a sure road to poverty.
That is why the exchange system, or the marketplace evolved. People specialised in a few skills. They sell their product in the market and bought what others produced. We can see countries doing the same. India can't produce everything that its citizens need. So, it specialises in a few products, that’s suitable for its climate, people, geography etc., and trades in the global marketplace for other products. We need to specialise because the opportunity cost of self-sufficiency is very high.
Government & Trade-offs
The idea of specialisation and opportunity costs apply to government actions too. As the great economist Thomas Sowell once said:
There are no solutions, there are only trade-offs.
When the government makes policies to intervene in a particular problem, they make trade-offs in the process, and there are opportunity costs associated. Public money spent on a particular policy is the money that could have been spent on some other policy. This is because the government budget is limited, and government's ability to raise money is finite.
Let me illustrate this by taking the case of India and comparing it with the United States on personnel, spending, and regulations.
Personnel: India has about one-fifth as many government employees as United States. For example, no. of judges per-capita in India is 12 per million. In US it is 108 per million.
Spending: The US federal government spending per-capita was 5 times higher in 1902 than Indian government's in 2006.
Regulation: Although there is lack of personnel and funds, India has essentially all the inspections, regulations, and laws of a developed country like US, and much more.
The more the regulations, the more the regulatory load on government employees and pressure on government budgets. For a country like India, where there is lack of enough personnel and funds, this will lead to inefficiency among government employees and misallocation of funds. In other words, the opportunity cost to regulatory overload is government not delivering on some of its most important functions like policing, efficient tax collection or timely justice delivery.
Do we need all the regulations and laws like a developed country given our lack of personnel and funds? What the Indian State needs to do is to be good in a few focussed areas (specialisation), instead of being bad or average in many. For this to happen, the opportunity cost of government involving in a particular sector needs to be understood, the trade-offs involved carefully negotiated.
As an aspiring policymaker, what do you think are the major areas where the government needs to focus? Why?
Homework:
1. Listen to this short podcast from EconTalk where opportunity cost is explained using an interesting example.
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