The Law Of Increasing Opportunity Cost And The Problem Of Big Government

Imagine a country that produces two kinds of goods, public goods and private goods.

Public goods are things like national defense. They benefit everyone and it is hard to stop non-payers from getting it (it would be hard to stop a non-payer from getting defended).

Private goods are those that only one person can enjoy and you can keep non-payers from getting it. A Big Mac for example. If you don't pay, you don't get it and if I eat a particular Big Mac, no one else can eat it.

What I am going to show is that as government gets bigger, it will actually get more expensive in terms of what we have to give up in the private sector. The bigger government gets, the more costly it is.

Now also imagine that this country has 5 workers. Some are better at making private goods (their skills are more entrepreneurial) and some are better at making public goods (their skills are more bureaucratic). The table below shows how much of each good each worker can make in a day if they only produced that good.

Notice that worker I is very good at making private goods, but not so good at making public goods (so he is more entrepreneurial and not so bureaucratic). Worker V is the opposite.

These kinds of numbers make sense-we know in the real world people don't all have the same abilities. There is a best plumber, a best doctor, etc. The best doctor is not likely to be a good plumber and vice-versa.

The next table will show all the combinations of private goods and public goods that we can produce if we are at full-employment. That is, if we use all workers.

If we started with all workers making private goods, we make 25 (and 0 public goods). But if we want to make some public goods, we need to move a worker. The best move is to have worker V start making public goods. We give up only 3 private goods and we gain 7 public goods.

If we want more public goods, we would then move worker IV, then worker III and so on.

But each time we do this, we give up a different and increasing number of private goods for each public good gained. The next table shows this.

At first, the cost of each public good is .429 private goods (3/7). We lose the 3 private goods that worker V makes and gain the 7 public goods he can make. But then when we move worker IV, we give up 4 to get 6. So that cost .667.

The more public goods we produce, the more costly they will be in terms of the private goods we have to give up. This is what makes the growing size of government so alarming. We can't see this so easily in the real world. Notice that the last public good costs 2.333 private goods, much more than the first one.

Here are some basic terms that economists use to discuss this issue:

Opportunity Cost-The value of the best foregone alternative. There is no such thing as a free lunch. If we want to build one more skyscraper, we may have to give up one submarine, since there may not be enough steel to go around (steel is scarce!).

The law of increasing opportunity cost-As more of a particular good is produced, the opportunity cost of its production rises. Why is the law of increasing opportunity cost true? Different resources are better suited to different productive activities. This is just about the same as saying people have different abilities, like some are more entrepreneurial and some are more bureaucratic.

Cut government spending to boost economy

This was by me and was printed in the San Antonio Express-News today. Here is the link: Cut government spending to boost economy. Here is the article in case the link does not last very long.

Re: “Laffer Curve a tool to help avoid fiscal cliff,” Other Views, Dec. 10:

Mickey Roth, the president of Intercontinental Asset Management, seems to think we need higher tax rates. I disagree.

He correctly explained the Laffer Curve, which relates tax revenue and tax rates. His reading of the historical record leads him to say the high tax revenue and budget surpluses of the late 1990s were due to raising the top tax rate to 39.6 percent in 1993.

We must realize that maximizing the federal tax revenue is not an official policy goal. The goals are low unemployment, low inflation and high GDP growth. Now if tax revenue is spent wisely on things like education and infrastructure, it can help the economy grow. But this is not always the case.

Higher tax rates hurt economic incentives. Investment decisions are made at the margin, based on after tax income.

As tax rates rise, some investments are no longer viable. Less investment, less growth. A slight change makes a big difference in the long run. For example, in 2010, liberal economist Paul Krugman mentioned that the per capita GDP since 1980 had grown 1.95 percent annually in the U.S. and 1.83 percent in the European Union, hinting that their higher tax rates were not a problem. But, if per capita income was $20,000 in both the U.S. and the E.U. in 1980, the per capita income now would be $1,372 higher in the U.S. at those annual growth rates. After 100 years, the U.S. income level would be 12 percent higher.

The harm taxes do to economic efficiency is called “deadweight loss.” It grows exponentially; more harm is done in raising rates from 35 to 40 percent than in raising rates from 30 to 35 percent. If the Bush tax cuts expire, some Americans in states like New York (which has its own income tax) will pay marginal tax rates of over 50 percent, if you include additional taxes to pay for Obamacare.

Roth says we should take a lesson from the 1990s. But in 1997 President Clinton agreed to cut the capital gains tax to 20 percent It is possible that the high tax revenue of the late 1990s was due to a fast growing economy which in turn was caused by the high tech boom and low oil prices.

Economist Alan Reynolds has said, “The unexpected revenue windfalls in President Bill Clinton's second term were largely a consequence of lower tax rates on capital gains.”

William McBride of the Tax Foundation found in a survey of studies that “lower-tax economies are more productive and that raising taxes has negative dynamic effects on revenue collection.”

Spending may be a bigger issue than tax revenue (Roth did call for less spending). As former World Bank Group president Robert Zoellick recently said, “Federal spending has traditionally been about 18-19 percent of the U.S. economy. It has now surged to 23-24 percent.”

Leszek Balcerowicz, the former central banker of Poland, says that countries grow rapidly out of recessions when they cut spending since this increases confidence in markets. Let's give that a try.

Cyril Morong, Ph.D., is an associated professor of economics at San Antonio College.