The importance of opportunity cost

John Allison, the wise and experienced banker who now heads the Cato Institute, has some thoughts on opportunity cost in the current issue of Cato's Policy Report. Here are some excerpts:

While opportunity cost is an easily understood idea, in many decisions individuals choose to ignore it. The current economic recovery is a classic example. It is very difficult for most people to understand the radical difference in economic well-being between 2 percent growth and 5 percent growth compounded even over just five years. Many people assume the stimulus package, increased regulations, and the Federal Reserve’s quantitative easing are critical to a recovery. They do not understand that a normal recovery is 5 percent growth and not 2 percent, and that these government interventions radically slowed growth.  

It is difficult for individuals to understand the damage the FDA does when it delays or stops drug development. It is easy to see when someone dies from the misuse of a medicine, but many cannot visualize the loss of life from bureaucratic delays. It is hard to grasp that the market would develop a rational quality control alternative (like Underwriters Laboratories, in electrical products) if the FDA did not exist. People have an emotional reaction to a single death from an unexpected effect of a drug, while it takes a conceptual leap — or an economics class — to see all the lives that could be saved without the FDA. 

Good teachers in government schools support their unions’ efforts to stop school competition. They fail to grasp the opportunity cost to them from the lack of competition. In a competitive education market, good teachers would be in strong demand and would be paid more. Public school unions protect mediocre and poor teachers. 

People see the benefits paid from Social Security. They have a hard time understanding that a like amount of savings properly invested would have created dramatically more income and more capital, driving faster economic growth. The opportunity cost of incentivizing government spending through governmental Social Security instead of incentivizing private savings is tremendous. 

People often see the world through the lens of the status quo. They cannot grasp how much better things could be if different opportunities were pursued. Fortunately, in private markets, entrepreneurs who do see the opportunities make them visible to the rest of us — Steve Jobs, Sam Walton, and Bill Gates are examples. This is one reason free markets radically outperform statism. 

I would also highly recommend John's book The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy's Only Hope. His is the best explanation of what caused the 2008 financial crisis that I have read. He takes you inside the crisis, viewing it from the perspective of a seasoned banking executive who has a deep grasp of how free markets work and how government regulations only make things worse.