ECONOMY - 21 AUG 2015

The Opportunity Cost of Spending

The Opportunity Cost of Spending
Broken Windows

"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken? 

– Frederic Bastiat

Oh the poor window glaziers. What on earth would happen to them if glass panes never broke? Or, imagine, what would happen to generator suppliers if power in Nigeria ran 24/7?

Moving beyond the ludicrous for a moment, we quickly discover the economic fallacy. Our concern for the plight of generator companies is commendable yet the sentiment is misplaced. In a country with constant power supply, Nigerians would find themselves with funds freed up from diesel expenditure, and these funds could then be directed to more productive uses. The real tragedy here is the opportunity cost (forgone benefit) of all the money spent compensating for epileptic power supply.

Many people, even those who should know better, overlook opportunity costs in this way. It happens because we erroneously associate the transfer of funds with creation of value and satisfy ourselves with understanding the obvious, first-order effects. 

Writing as far back as in 1850, Frederic Bastiat sketched the argument as a distinction between what is seen and what is not seen. The effect on the glazier – increased revenue from his trade, is seen, yet there is an unseen effect – the lost income of another trader, Bastiat uses the example of a florist, who would otherwise have benefitted. So which effect is greater?

In Nigeria, the unseen effect – the unrealized gain, is greater. This illustration explains how: A young, middle-class mother moves to a neighborhood in Lagos that has experienced a spate of robberies with an underwhelming police response. She has the choice between employing private security personnel to ensure her family’s safety or enrolling in a short course at the Lagos Business School. Only in the latter case will real value be created. 

Expenditure on security personnel would be expenditure to maintain the status quo because the government has already directed funds towards providing effective security. Meanwhile, forgoing the course implies forgoing an opportunity to increase her productive potential – an improvement on the status quo. Similarly, when a window breaks and the glazier fixes it, he simply restores the previous status quo so no new value is created for that particular society.

Many people intuitively understand that some expenditure is more productive than others. Spending on education and medical research is generally seen as more valuable than spending on luxury brands. Likewise, most countries acknowledge this by distinguishing between recurrent and capital expenditure in their budgets. 

Yet this distinction alone is unable to stop us from falling into the opportunity cost trap. For example, not all road infrastructure projects are executed to the sufficient quality and this sometimes leads to more funds allocated to these roads for reconstruction in the future. Furthermore, as it has been documented that increasing road capacity leads to an increase in road use, capital spending in this area has higher-order congestion and pollution effects that erode its economic value compared to alternative uses. Put simply, going further to understand higher-order effects can help governments identify the most productive areas of capital spending.

On an individual level, there is an activity that is surprisingly relevant here – paying “taxes” to touts and corrupt security officials. At some point, a frustrated victim may have been consoled by an observer who asks, “How else will the policeman account for the shortfall in his income caused by low wages and inconsistent pay?” Or something along those lines at least. Beyond the moral implications of such questions, there is an economic problem as opportunity costs rear their head again. Each time I pay my “tax” to a Lagos tout or corrupt policeman, I miss out on the other productive uses those funds could be put towards. 

A higher order economic analysis might identify the possibility that the tout could put the funds to a more productive use than I would have yet even this possibility ignores the consequent erosion of trust and distortion of work incentives that such a system would promote. Needless to say, the opportunity costs of corruption are very high.

Individuals and nations must have an understanding of the economic value of their spending. Outlining recurrent and capital expenditure is merely the starting point. A more sophisticated approach would also consider opportunity costs and higher order effects. Many people may choose not to do so when the personal cost of oversight is minimal. However, for a nation managing its finances, it becomes economically imperative.

 

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Kitan Williams

Kitan Williams

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