9. OPPORTUNITY COST
In the context of scarcity, the central concept that we discussed was efficiency, that is, acting with a minimum of expense, effort and waste. In this very context (i.e., scarcity), a second central concept is cost because we can seldom get something for nothing. We have to incur costs to obtain benefits.
Broadly, cost is the measure of what has to be given up in order to obtain something whether by way of purchase, exchange or production. There are two concepts of costs which need to be distinguished:
(a) Outlays: This is an accountant’s concept of costs. An accountant defines the cost of something as the total money expenditure or outlays necessary to achieve it.
(b) Opportunity Cost: This is perhaps the most fundamental concept of economics. Opportunity cost measures costs as the value of the alternatives or other opportunities which have to be foregone in order to obtain a particular thing. This will coincide with outlays (total money expenditure), if and only if the prices with which the outlays are calculated correctly reflect the value of alternative uses of the resources.
Opportunity cost can only arise in a world where the resources available to meet unlimited wants are limited so that all wants cannot be met. In a world of unlimited resources (means), no want would be satisfied at the expense of any other-no alternative will be foregone and so the value of alternative will be zero.
The principle of opportunity cost involves asking what is actually foregone in choosing a particular alternative. This concept of cost is preferred by economists because it leads to a more rational process of decision-taking. It (this process of decision-taking) allows the decision-taker to compare the returns from a course of action with the real cost involved in it.
In many cases, the opportunity cost of doing something is properly measured in terms of money cost (outlays). The opportunity cost of spending one hundred rupees over a shirt is the loss of opportunity to spend the same amount on a book instead. Where activities involve no money cost, opportunity cost can be explained in terms of time. An hour spent over the study of economics, for instance, is an hour not available for studying mathematics or history.
The production possibility frontier, given above in this chapter, is a graphical illustration of opportunity cost. Each movement along the frontier means the sacrifice of the opportunity to produce one thing in order to produce more of something else.
10. TYPES OF EQUILIBRIUM
As defined in section 1 of this post, equilibrium is a state of rest. It is a position from which there is no incentive or opportunity to move. The concept of equilibrium is very important in economic theory. So we must know the various types of equilibrium concepts. Equilibrium may be:
(i) Static, Comparative Statics Dynamic and Stationary State;
(ii) Stable and Unstable;
(iii) Partial and General;
(iv) Single and Multiple; and
(v) Short-period and Long-period.
(i) Static, Comparative Statics, Dynamic and Stationary State
(a) Static: A static analysis is one where we try to understand what determines an equilibrium position at any moment in time. In this equilibrium analysis all economic variables relate to the same point of time and there is no attempt to explain the path by which the system reaches a position of equilibrium.
As Bohr says, “The necessary and sufficient condition for a static equilibrium state is that the outcome of the adjustments not only be determinable and thus constant at a moment in time but also constant through time.” J.R. Hicks suggests that “We call Economic statics those parts of economic theory where we do not trouble about dating.” Take an example.
An entrepreneur employs certain quantities of factors and produce certain quantities of the product. In static equilibrium analysis we do not ask when the factors were employed and when the products came out. Joseph Schumpeter explains it in terms of the time subscripts. In static economic analysis, relations between economic variables are expressed in such a way that all the time subscripts refer to the same point of time. Thus price-quantity relationship in demand theory refers to the same point of time. Symbolically,
Qt = f (Pt)
It means that quantity purchased of commodity in the time period ‘t’ is a function of its price in the same period of time ‘t’. So if there is no change in the determining factor (price in the above example), an equilibrium position that applies to the present will apply equally well to the future.
In fig, a static equilibrium position has been shown. E is such a situation where the demand for the commodity equals its supply.
If there is no change in the price of the commodity X, the determining factor, the equilibrium position E will remain constant and there will no tendency to change it.
The static equilibrium analysis is suitable for analyzing some of the theories of traditional economics like the theory of rent, the theory of comparative cost, the theory of monopolistic exploitation, etc.
These theories can be explained without any consideration of time. But this analysis is not competent to deal properly with capital, interest, trade fluctuations or money. Here consideration of time assumes importance and the analysis becomes dynamic. But before coming to dynamic equilibrium we explain the intermediate situation of comparative statics.
(b) Comparative Statics: In static analysis, certain parameters like tastes, income, etc are assumed as given and then a functional relation is established between two variables, say price and quantity. “The change from one equilibrium position to another is the subject matter of comparative statics,” says Hansen.
In the words of Samuelson, comparative statics is a study of “the way in which our equilibrium quantities will change a result of changes in the parameters taken as independent data.” In comparative static analysis we omit consideration of dynamics and compare the initial and final equilibrium situations. This analysis leaps over the time involved in the transition from the initial to the successive positions of equilibrium, as shown in Fig.
The initial position of equilibrium in Fig. is E1. As a result of price fall from P1 to P2 due to an increase in supply shown by the new supply curve, the equilibrium position shifts from E1 to E2.
In comparative static analysis we thus view the historical behaviour of the determinate variable as one of successive static positions. “Our frame is statical”, says Bohr, “even though we are concerned with those positions at different points in time. We are seeing the system as one of changing static points-that is, comparative statics—and have thus jumped over any involvement in the path of transition from one point to another.”
(c) Dynamic Equilibrium: Comparative statics focuses attention on equilibrium positions before and after changes in the determining variables. It does ‘not, however, “reveal the behaviour of the determined variable as it travels the path from one static position to another,” says Bohr. “To discover this”, be continues, “We study the movements of the variable in a dynamic setting. We are interested in knowing not only what the ultimate change is and why it occurred but also how it came into being.”
The intertemporal analysis of the economic system is the dynamic economic analysis. The essence of such analysis is the introduction of lags in the adjustment of variables. In an analysis of lagged adjustments, the current values of the variables depend on past values of these very variables and/or other variables. This is done in period analysis, as shown below
Ct = f(Yt-1)
The above equation shows that an individual’s consumption in the current period of time ‘t’, that is, today depends on his income of yesterday, that is, past period of time ‘t-1′. This is the case of lagged adjustment. This is an illustration of the Robertsonian period analysis.
Ragnar Frisch considered dynamic theory to be one in which:
“….. We consider not only a set of magnitudes in a given point of time and study of inter-relations between them, but we consider the magnitudes of certain variables in different points of time, and we introduce certain equations which embrace at the same time several of those magnitudes belonging to different instants. This is the essential characteristic of a dynamic theory. Only by a theory of this type can we explain how one situation grows out of the foregoing.”
Following Frisch, Hicks defined “Economic Dynamics those parts (of economic theory) where every quantity must be dated.” In economic dynamics, we ask when, for example, the factors are employed and when the products come to be ready.
But R.F. Harrod says that “It would be wrong to regard change as such as belonging to the dynamic field. Problems arising from a once-over change can, I believe, be satisfactorily handled by the apparatus of static theory. It is when we come to a steadily continuing change that we have to consider a different technique….. Dynamics will specifically be concerned with the effects of continuing changes and with the rates of change in the values that have to be determined.”
Continuing he says further, “Then dynamics would be concerned with an economy in which the rates of output are changing; we should have as the correspondent concept of velocity in Physics—a steady rate of change (of increase or of decrease in the rate of output per annum; acceleration (or deceleration) would be a change in the rate of change.” Thus dynamic economic analysis deals with the changing rate of change. To Schumpeter, in dynamic economic analysis, “We are led to take into account past and (expected) future values of our variables, lags, sequences, rate of change, cumulative magnitudes, expectations and so on.”
Recently, however, according to Alpha C. Chiang, “The term dynamics has acquired an almost exclusive usage; it now refers to the type of analysis in which the object is either to trace and study the specific time paths of the variables or to determine whether, given sufficient time, these variables will tend to converge to certain (equilibrium) values.”
In other words, economic dynamics is that part of economics which analyses the movement of economic systems through time. Relationships are explicitly time-dependent and contain variables whose values may change our time.
From the above discussion it follows that the dynamic analysis has different meanings for different economists. When variables are dated, consideration of time is introduced into the picture.
This is one chief feature of dynamic analysis. Cobweb theorem is an oft-quoted example of dynamic analysis. “An important recent development has been the extension of the theory from the analysis of time paths of variables ‘mechanistically generated by a model, to the search for optimum time paths, such as the optimum growth path for the National Income…..” –The Penguin Dictionary of Economics, pp. 144-145.
(d) Stationary State: There are two concepts of stationary state. For most of the classical economists, from Adam Smith on, “stationary state was an actual condition of the economic process which they expected to materialize sometime in the future,” says Schumpeter. Thus stationary state was a future reality.
The other sense in which this term stationary state was used was that it was an analytical tool. Here a stationary state was not a future reality but only a conceptual construct or a tool of analysis or a methodological fiction. Hicks believed that stationary state was nothing but an evasion. “The stationary state”, observes Hicks, “is that special case of a dynamic system where tastes, technique, and resources remain constant through time.” -Value and Capital, p. 117.
In order to study the influences exerted by the element of time on the relations between cost of production and value, Marshall considered, what he called “the famous fiction of the “stationary state’. The general conditions of production and consumption, of distribution and exchange remain motionless, yet full of movement.
In order to illustrate this he says that, “The average age of the population may be stationary; though each individual is growing up from youth towards his prime, or downwards to old age.” He further says that, in order to bring this concept nearer to real life, it may be modified.
In this state population and wealth are both growing but at about the same rate. Further, “in such a state by far the most important conditions of production and consumption, of exchange and distribution will remain of the same quality, and in the same general relations to one another, though they are all increasing in volume.” In this way Marshall tried to increase the usefulness of this concept for analysis by defining it differently for different purposes.
The stationary state analysis is different from static theory where time is not considered: it is a special case of dynamic analysis where tastes, technique, and resources remain constant through time.
(e) Uses of Static Analysis-Advantages and Disadvantages: Usefulness: Static economic analysis is mostly unrealistic and unsuitable for most of the purposes. Its advantage, however, lies in the fact that it possesses the virtue of simplicity and it is quite a significant fact. The study of the working of a propeller while it is standing is much easier than while it is in motion.
Similarly, it is not only useful but also necessary that a complete understanding of each and every part of the economic machine is acquired but it moves. It is true that the economy can never stop. But the beauty of the static analysis lies in the fact that it allows the machine to move but at a constant rate without hampering our task.
So Zenthen points out that, “We should emphasize that the static theory has an introductory pedagogical value.” This value is the gain in clarity and precision resulting from the study of economic phenomena is isolation from the past and the future through higher degrees of abstraction. As Marshall states, “The economist seggregates those disturbing causes whose wanderings happen to be inconvenient for the time being in a phrase called ‘ceteris pasibus’.”
Apart from simplicity and clarity, the method of static analysis provides us with a hypothetical model of the economic phenomena in a state of unchangeability. This model helps us in comprehending the consequences of certain changes. This in itself is no small contribution. It is for the reason that the crux of any scientific discipline lies in the discovery of the consequences.
Static analysis studies the states of equilibria. Such a study provides us an end view of the forces in operation and in a sense end is more important than what happens along the path to the end.
Writing on the usefulness of static analysis as a simplifying process, Marshall says, “The forces to be dealt with are so numerous that it is best to take a few at a time; and to work out a number of partial solutions as auxiliaries to our main study.
Thus we begin by isolating the primary relations of supply, demand and price in regard to a particular commodity; we reduce to inaction all other forces by the phrase ‘other things being equal’. We do not suppose that they are inert, but for the time we ignore their inactivity…. In the second stage, more forces are released from the hypothetical slumber that had been imposed on them. Gradually the area of the dynamical problem becomes larger; the area covered by provisional statical assumptions becomes smaller.”
It is only through the method of static analysis that the various types of allocative problems of the economy are studied. For the individual allocation problem concerns maximizing satisfaction, while maximizing profit concerns the producer.
The significance of economic statics lies in penetrating the complex problems in a simple way.
Limitations: It is removed from reality. It assumes variable data such as population, tastes, resources, and techniques, etc. as constant. In the actual world, these data are continuously changing.
Conclusion: In spite of its limitations and the intrusion of dynamic consideration into economic analysis, the core of economics has remained static.
(f) Significance of Dynamic Analysis: Dynamic analysis is more realistic and light giving than static method. It provides a conspectus of the process of change and not just an analysis of the equilibrium position. Resources, population, state of technique, investment, tastes, etc., all change. For a proper understanding of the influence of these variables, there is no escape from dynamic analysis. It is this analysis that takes into consideration the changes, lags, sequences, cumulative magnitudes and even expectations.
This analysis has assumed importance in the field of those economic problems which involve time-lags, sequences and the rates of growth, Economics is fast becoming Econometrics owing to the increasing use of dynamic analysis. Writing on the significance of dynamic method, Samuelson says that it “is an enormously flexible mode of thought both for pinning down, the implications of various hypotheses and for investigating new possibilities,
In spite of the enormous usefulness of the dynamic analysis, it suffers from certain limitations. It is very complicated and complex. It can be used by only those who are equipped with advanced mathematics. The building up of the theory of economic dynamics requires certain fundamental conditions which the economic data do not possess. Human wants are not amenable to dynamic analysis because future structure of wants cannot be derived from present wants.
In fact, dynamic and static methods of economic analysis are two inseparable wings. “If the economic dynamics is a movie of a functioning economy, static is a still depicting the stationary position of the economy.”