Investment decisions need to consider different options, trade-offs and opportunity costs to ensure an efficient economy
When you go into a supermarket, grab a trolley and shop around the store you have a lot to choose from. Which vegetables do I want? Shall we have steak tonight or is chicken more of a family favourite? Can I get away with spending our entire week's budget on chocolate or will my partner be mad?
These types of questions are essential, as ultimately they help you leave the store with the basket of goods you want. You could have chosen different products, but you haven't.
This illustrates the economic concept of opportunity cost - the next best alternative use for your money. Or also defined as the value of resources if they were put to the next best alternative.
In this case, the opportunity cost is the different basket of goods from the supermarket. However, for most consumers, opportunity cost isn't this explicit, and consumers often fail to consider different options and the opportunity cost. It is crucial to consider the opportunity cost of different options so that limited funds can be put to good use.
You have to be a bit careful with opportunity cost though. Taken too literally the opportunity cost of time spent relaxing and watching a movie could be the money you would make working. Relaxation tends to be a lot less enjoyable 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 on alternative uses for the money
Budget-setting processes often simply reallocate funding from one year to the next with limited consideration as to whether funds are being put to their best use. Sure, at some point, there may have been an argument for funding allocation decisions, but legacy funding arrangements can persist for decades without challenge.
Disinvestment isn't talked about as often as it should be because it's much easier to do things as they were done before. Plus, removing funds from an existing funded programme, product or service can make people a bit shitty.
Granted there is value in continuity - but imagine how differently funds would be allocated if all existing spending had to be justified. There is serious value in reviewing existing funding arrangements, such as the ability to repurpose funds for better uses, or simply reduce cost/debt.
When new money is being invested, governments and businesses generally do a better job at considering the options - but often the range of alternatives considered is too narrow and decision-making is politicised.
Evaluation of options and opportunity costs is essential to address scarcity and avoid misallocation
Proper evaluation of options is crucial to an efficient economy.
Scarcity is a fundamental principle of economics which stipulates that there are limited resources compared to people's wants. Because of this, governments and businesses need to make choices about where resources are allocated.
Different choices must be evaluated against each other to properly understand opportunity cost and ensure scarce funds are put to good use - whether it be in the pursuit of profit or social good.
Evaluation of options and opportunity costs is often a missing piece of analysis, with decision-makers being selective with the evidence they choose to use, favouring special interests or just generally being lazy. The result is that the best investment decisions are overlooked, causing a misallocation of resources.
Misallocation of resources can create economic distortions with spending on things that may not matter that much.
Opportunity cost isn't felt as strongly when spending someone else's money, which makes it all the more crucial for the public sector to evaluate the opportunity cost
There is evidence to indicate that opportunity cost is not considered to be as important for public policy as it is for private consumption. This makes sense as that public investments are coming from a shared pool of resources - ie taxpayers.
Plus, it's often not clear exactly what the alternatives for public spending are. It's not as if Chris Hipkins is going to stand up and say "we spent $10 million on teachers instead of on medicines, doctors, nurses, roads, trains, buses...". The list is too long.
However, this makes it all the more important for the public sector to consider feasible options and opportunity costs so that limited funds can be put to good use.
It is worthwhile to construct a notional "average" public investment across a range of sectors (e.g. health, infrastructure, education), and measure benefits such as jobs and GDP of this. This "average" investment could be a point of comparison for spending new money. Theoretically, if spending didn't do better than this average by a reasonable margin, it should not be undertaken.
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