Investment decisions must consider different options, trade-offs and opportunity costs to ensure economic efficiency
When you go to the supermarket, take the trolley and shop around the store you have a lot to choose from. Which vegetables should I eat? Should we have steak tonight or the family favorite chicken? Can I spend the whole week’s budget on chocolate or will my partner get mad?
These types of questions are important, as they ultimately help you leave the store with the basket of items you want. You might choose a variety of products, but you don’t.
This illustrates the economic concept of opportunity cost – the next best alternative use of your money. Or it is also defined as the value of the resource if it is included in the next best alternative.
In this case, the opportunity cost is to buy something different from the supermarket. However, for most consumers, opportunity costs are not clear, and consumers often fail to consider different options and opportunity costs. It is important to consider the opportunity costs of different options so that limited funds can be put to good use.
You have to be a little careful with the opportunity cost though. Taken literally, the opportunity cost of time to relax and watch a movie can be money you’ll spend. Relaxation tends to be less exciting 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 for the money
The process of setting a budget often simply transfers funding from one year to the next with limited consideration of whether the funds are being best used. Of course, at some point, there may be arguments for funding allocation decisions, but legacy funding arrangements can continue for decades without challenge.
Disinvestment is not often talked about because it is easier to do things like before. Also, removing funding from a program, product or service that has been funded can make people a bit upset.
There must be ongoing value – but imagine how different the 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 reuse funds for better use, or simply reduce costs/debt.
When new money is being invested, governments and businesses generally do a better job of considering options – but often the few alternatives are narrowly considered and decision-making is politicized.
Evaluating options and opportunity costs is essential to address shortages and avoid over-allocation
Proper evaluation of options is essential for an efficient economy.
Scarcity is a basic principle of economics that states that resources are limited compared to people’s wants. Because of this, governments and businesses must make choices about resources.
Different options must be properly evaluated to understand the opportunity cost and ensure that scarce funds are used – whether they are for profit or social good.
The evaluation of options and opportunity costs is often a missing analysis, with decision makers being selective with the evidence they choose, favoring special interests or just generally being lazy. The result is that the best investment decisions are ignored, leading to a misallocation of resources.
Misallocation of resources can create economic distortions by wasting non-essential goods.
Opportunity costs are not felt strongly when spending other people’s money, which makes the public sector more important to evaluate opportunity costs.
There is evidence to show whose opportunity costs are not considered important for public policy as for personal consumption. This makes sense because public investment comes from shared resources – ie taxpayers.
In addition, it is often not clear exactly what the alternative to public spending is. It’s not like Chris Hipkins is going to stand up and say “we spend $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 for the public sector to consider feasible options and opportunity costs so that limited funds can be put to good use.
It is useful to construct an “average” public investment in several sectors (e.g. health, infrastructure, education), and measure the benefits such as jobs and GDP. This “average” investment can serve as a point of comparison for spending new money. Theoretically, if spending is not better than this average by a reasonable margin, it should not be done.
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