Tuesday, February 16, 2010

Public Policy and Opportunity Costs

Tyler Cowen has an interesting post about the likely affects of increasing health insurance coverage. He's raising a really basic point that somehow is often forgotten: when deciding whether to pursue some policy the test is not whether the policy would "do some good," but rather the test is whether the policy is the best option available. Economists refer to this as "opportunity cost," and I think it's one of the most important ideas in all of economics. [Wiki attributes the idea to John Stuart Mill, but I wouldn't be surpised if it was thought of thousands of years ago avant la lettre. Maybe Aristotle or Plato talked about it?] Basically, the opportunity cost of something is the next best option available to you that you must forego to get the thing you end up choosing. That sounds complicated, but think of opportunity cost as what you have to sacrifice in order to get something. Example: the cost of going to law school isn't just the outrageously high tuition. It's also the three years of income you had to give up. And we can extend this to non-financial concepts as well: you had to give up a lot of sleep, maybe give up blogging, etc. We realize that the cost might be way higher than we thought at first.

So, when you are deciding whether to buy an ice cream cone, don't just ask: Would I like an ice cream cone? You probably would answer yes. And this logic would lead you to spend thousands of dollars on ice cream per year. Ask instead, what else could I spend this money on? Do I like these things better than ice cream? Now you'll behave in a more reasonable fashion: buying ice cream here and there, but also purchasing other important things, like clothing or housing or education.

The above sounds really obvious, and it might describe the way most of us act most of the time, but I think we often forget this common sense in policy debates. So, someone will say that of course we should spend more money on education. It's "for the children" after all. Who could be stingy when it comes to that? And then the environmentalist comes along and asks you to spend some money to save the environment. And surely you can't skimp on that. And soon enough you realize that you've run out of money, and you haven't even tipped the waitress for lunch yet. Oh yeah, and you forgot to pay for national defense, a police force, health insurance, etc. Oops.

Tyler Cowen makes a very convincing case that there would be much better, politically feasible ways to spend the money that the Democrats would like to spend on their health reform proposals. Bjorn Lomborg makes similar arguments regarding climate change. If you haven't already, I recommending doing a youtube or google video search of Lomborg's interviews or lectures. He's a very powerful speaker.

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