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Opportunity Cost and Cost of Production

July 3, 2013

We’ve got a world with many natural resources, each one of which can be used to produce a staggering number of different goods each one of which can satisfy a variety of human desires. Making the decision of what resources to use to make which goods to allocate to which people so that they can satisfy which goals is neigh impossible. The difficulty of this calculation was first described by Ludwig von Mises during the socialist calculation debate of the 1920’s.

A Simple Model
The opportunity cost of any action is what you have to give up to do it. If you use your time to go to the movies, you can’t use that same time to go to the gym. If you use flour to bake a cake, you can’t use that same flour to bake bread, etc.

Let’s start with a world with only one natural resource (arable land) which can be used to produce only two goods: apples and oranges. Let’s assume that everyone is equal in every way, except for their demand for these two goods. There is a demand curve for apples and a demand curve for oranges. One unit of land can produce either 200 apples or 100 oranges.

Demand for fruit

Because of diminishing returns, the first few of each fruit will be valued highly by people, but when there are a lot of that particular fruit, people won’t demand them as much. Land which is used to grow apples cannot be used to grow oranges. Even though the opportunity cost of 2 apples is always one orange, the more apples are made, the more costly producing apples is in terms of welfare/utility. Even if you know the exact cost in terms of resources it takes to produce apples, you can’t know how many apples to produce without knowing how much everyone values those fruits.

Let’s move to a world with many goods, but still only one resource. Just as before, producing more of one good means producing less of everything else, but now instead of needing to know the demand for oranges to accurately figure out how many apples to grow, you need to know the demand curve for all other goods. To allocate additional land to apples means not only taking away land from oranges, but also avacados, broccoli, and everything else, on the margin. Already, this is starting to look like one heck of a hard calculation.

Once you add in the fact that there are a staggeringly huge number of various resources of production, things get even worse for the would be social planner. Let’s say sandier soil is good for oranges and worse for growing apples. Maybe you should grow oranges there. But wait! What if people really really like apples? Maybe even the sandy soil should be used for them despite the lower productivity. Should iron be used for cars, or for lawn mowers? Should silicon be used to make PCs or cell phones? The choices are endless and require tradeoffs reflecting the value of not just one person but literally everyone in society.

Each time you make a purchase, you are directing resources toward making that good and away from making other goods. If you buy a coat you are directing clothing makers away from making pants. If you buy clothes made out of cotton, you are directing farmers to grow more cotton and shepards to raise fewer sheep and maybe use their land for grazing another type of animal instead. The decisions of countless individuals buying countless goods add together using the free market to direct production in a way far more refined and elegant than any single decision maker could possibly manage.

It’s not just the fact that producing requires forfeiting a quantity of some other good. It’s also that each good made and each good given up is valued in different ways by different people in an entirely subjective way. To trump the free market using government is to trump all of the decisions made by all the people who would otherwise have used those resources. It’s not a decision that should be made lightly.

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