Economic Opportunity Costs

The conceptual approach for calculating economic opportunity costs assumes that governments purchase inputs for use in their own projects in fairly well-functioning, but distorted markets. As a result of their purchases, governments add to the existing market demand and consequently bid up the price of goods and services. The approach further assumes that the additional government demand is satisfied either through (a) reduction of consumption of the good on the part of existing consumers, (b) increased production of the good on the part of existing producers, or (c) a combination of both.

The value to society of the goods or services diverted to the project is the sum of the values consumers place on the forgone consumption, plus the cost of increasing production. This conceptual framework is based on the following three basic postulates:

• Competitive demand price measures the benefit of each marginal unit to the demander.

• Competitive supply price, or marginal cost, measures the opportunity cost of each marginal unit from the suppliers’ standpoint.

• The benefits and costs to a society as a whole are equal to the difference between benefits and costs.

These three postulates imply that in a distortion-free, well-functioning market, the market clearing price measures the benefit of each marginal unit to the demander and also measures the cost of each marginal unit for the supplier. In such a market, the social opportunity cost of goods and services equals their market clearing prices, which in turn implies that society’s cost of transferring one unit of a good to a government project is given by the market price of the good.

Distortions and externalities destroy this appealing symmetry. A distortion such as a sales tax introduces a wedge between the prices that demanders and suppliers face. In such cases the marginal social benefit, as measured by the price paid by demanders, differs from the price that suppliers face by the amount of the tax. As a result, we can no longer rely on the market price as an indicator of the cost to society of transferring one unit of a good to a government project, because there are now two prices: the price that demanders pay and the price that suppliers receive.

When the government demands goods and services in distorted markets, the question that arises is: Which price reflects the economic cost to society? If a reduction of consumption by existing demanders satisfies the additional government demand, then according to the first postulate, the cost to society will be the value consumers place on the forgone consumption.

The value of one additional unit will be given by the price that demanders pay. If an increase in production solely satisfies the additional government demand, then according to the second postulate, the cost to society will be the cost of increasing production and the value of one additional unit will be given by the price that producers receive.

If a diversion of existing demand and an increase in supply satisfies the additional demand, the third postulate implies that the value to society of the goods and services diverted to the project is the sum of the values consumers place on the forgone consumption plus the cost of increasing production. The relevant price will be a weighted average of the supply and demand prices.

This basic approach can be used to estimate the economic opportunity cost of every resource, including foreign exchange, labor, and capital. The basic principle is the same. We view the government as an additional demander of a resource. This additional demand bids up the price of the resource, and consequently the quantity required by nongovernment demanders falls and the quantity supplied rises. The additional government demand is partly satisfied by the displacement of existing consumption and partly by the increase in production. The value to society of the resources used equals the sum of the values consumers place on their forgone consumption and the cost to suppliers of the additional production.

In distorted markets, the difference between the financial and economic price is indicative of a rent that someone in the economy receives. If taxes are the source of the distortion, the difference between the economic and financial prices indicates the amount of taxes that the government forgoes. If the distortion stems from monopoly power, then the difference between the financial and the economic price signals a change in monopoly rents. For example, suppose the government was to purchase goods in a market subject to a sales tax, and the supply of those goods was completely inelastic. The additional government demand would have to be satisfied solely from reduced consumption. Total consumption and production would remain the same, but government revenues would fall.

Similar analysis applies in every instance where the financial and economic prices and flows differ. If the source of the distortion is monopoly power, a government purchase that stimulates supply would increase monopoly rents. If the source of distortion is quantitative restrictions (QRs), then those enjoying the benefits of QRs would gain. Whenever economic and market prices differ, some group other than the project entity, either pays a cost of the project or enjoys some of its benefits.

Identifying the sources of divergence between economic and financial prices and flows helps assess gainers and losers. Because taxes are a common source of divergence, full use of the information available helps assess the fiscal impact of projects. Putting together the financial information, the fiscal implications, and the distribution of costs and benefits among the various actors in the economy creates a richer and more informative analysis.