Investment decisions must consider different options, trade-offs, and opportunity costs to ensure an efficient economy.
When you go to a supermarket, take a cart and shop at the store, you have a lot to choose from. What vegetables do I want? Do we have steak tonight or is chicken more of a family favorite? Can I get away with spending our entire week’s budget on chocolate or will my partner be upset?
These types of questions are fundamental, since in the end they help you leave the store with the shopping cart you want. You could have chosen different products, but you didn’t.
This illustrates the economic concept of opportunity cost: the next best alternative use for your money. Or also defined as the value of the resources if they were placed in the next best alternative.
In this case, the opportunity cost is the different basket of goods from the supermarket. However, for most consumers, the opportunity cost is not so explicit and consumers often do not consider the different options and the opportunity cost. It is crucial to consider the opportunity cost of the different options so that limited funds can be put to good use.
However, you have to be a little careful with the opportunity cost. Taken too literally, the opportunity cost of time spent relaxing and watching a movie could be the money you’d earn from working. Relaxation tends to be much less pleasant for economists.
Defining and evaluating options is a key challenge in public and private investment decision-making.
Often budgets are simply reallocated with limited critical thinking about alternative uses of the money.
Budgeting processes often simply reallocate funds from one year to the next with limited consideration of whether the funds are being used in the best way. Sure, at some point, there may be an argument for funding allocation decisions, but legacy funding arrangements can persist for decades without issue.
Divestment is not talked about as much as it should be because it is much easier to do things as before. Also, defunding an existing funded program, product, or service can turn people a little mean.
Granted, there is value in continuity, but imagine how funds would be allocated differently if all existing expenses had to be accounted for. There is great value in reviewing existing financing arrangements, such as the ability to repurpose funds for better uses, or simply reduce cost/debt.
When new money is invested, governments and companies generally do a better job of considering the options, but often the range of alternatives considered is too narrow and decision making is politicized.
Assessing options and opportunity costs is essential to address shortages and avoid misallocation
Proper evaluation of options is crucial for an efficient economy.
Scarcity is a fundamental principle of economics that stipulates that there are limited resources compared to the needs of people. Because of this, governments and companies must make decisions about where resources are allocated.
Different options need to be weighed against each other to properly understand opportunity cost and ensure that scarce funds are put to good use, whether in the pursuit of profit or social good.
Assessing the options and opportunity costs is often a missing piece of the analysis, as decision makers are selective with the evidence they choose to use, favor special interests, or are generally lazy. The result is that the best investment decisions are overlooked, leading to a misallocation of resources.
Misallocation of resources can create economic distortions with spending on things that may not matter as much.
Opportunity cost is not felt as strongly when someone else’s money is spent, making it even more crucial for the public sector to assess opportunity cost.
There is evidence to indicate that opportunity cost is not considered as important for public policy since it is for private consumption. This makes sense since public investments come from a shared pool of resources, that is, taxpayers.
Furthermore, it is often not clear exactly what the alternatives are for public spending. It’s not like Chris Hipkins stood up and said “we spent $10 million on teachers instead of medicine, doctors, nurses, roads, trains, buses…”. The list is very long.
However, this makes it all the more important that the public sector consider feasible options and opportunity costs so that limited funds can be put to good use.
It is worth constructing a notional “average” public investment in a variety of sectors (eg health, infrastructure, education) and measuring the benefits as jobs and GDP from this. This “average” investment could be a benchmark for spending new money. Theoretically, if spending was not better than this average by a reasonable margin, it should not be undertaken.
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