Friday, December 16, 2011

Opportunity costs

Part 1: What is "real"? (commentary)
Part 2: Opportunity costs

To look at real economics, we're looking at economics in the absence of money. It's important, I think, to revisit a little of microeconomics 101 in real terms.

One thing that doesn't change in real micro is the production possibility frontier (PPF). The PPF basically represents the notion that, ceteris paribus, we can make only a finite quantity of goods: if we make more pizza, for example, we cannot make as much beer, and vice-versa. Since both axes are in quantities of real goods and services, money is not involved, and nothing changes between financial and real microeconomics.

A concept that does change is the partial equilibrium "price" given by the intersection of the supply and demand curves. In standard financial micro, the x-axis is the quantity of some real good (so it's the same in real economics), but the y-axis is the price, denominated in money. Since we don't have money in real economics, we need a new unit of measure for the y-axis. To get the y-axis, we need a narrative about why the demand curve decreases and the supply curve increases.

The demand curve falls because for any single good or service, the more units we already have, the less we "inherently" want yet another unit: the declining marginal utility of demand. The first hamburger keeps me from starving to death, the second makes me feel full, I want the third just because I really like hamburgers, and so forth. The the fifth or sixth hamburger might have negative utility: it'll make me sick. Not all goods and services are like this (think of Imelda Marcos and shoes), but overall it seems intuitively to hold, especially when we start talking about each individual consuming many different goods and services, and each supplier producing for many different consumers.

There are two reasons the supply curve falls. First, there are, especially in the short run (where one or more of the factors of production: land, labor, and/or physical capital are fixed), diseconomies of scale. If I have a certain number of pizza ovens, I can make only so many pizzas, no matter how many pizza-makers I hire. Similarly, for the pizza sector, we can't just magically make more pizza ovens overnight. Even trying to squeeze the maximum productivity out of the pizza ovens we already have becomes less and less efficient.

More importantly, though, if demand "inherently" falls, then, because of the PPF above, if we make more units of one good or service, we must make less of other goods and services. The first, most demanded pizza we make means we must forego the last, least demanded beer we could otherwise have made. The second, slightly less demanded pizza requires foregoing the second to last, second least demanded beer. At some point, we're going to have a coin-flip between the pizza and beer that are equally demanded. Thus the supply curve rises even in the long run (where no factors of production are constrained) because of rising opportunity cost.

We can also talk about demand not just in terms of "inherent" desire, but also in terms of opportunity cost: the "inherent" desire for one good or service minus the "inherent" desire for the most desirable good or service we have to give up to get the first. So in real micro, we can always think of the "price" axis (usually the y-axis) in financial micro as the opportunity cost.

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