Welcome to another edition of The Mueller Report!
This week I have an extended reflection (one might even say ramble) on the most important concept in economics, opportunity cost, and its connection to rapidly declining birth rates and changes in parenting.
Before diving in, let me share two great quotes about some benefits of market exchange:
The essential feature of the market [is]…that it separates the economic activities of the individual from his political ideas or activities and in this way provides individuals with an effective support for personal freedom. The person who buys bread doesn’t know whether the wheat from which it was made was grown by a pleader of the 5th Amendment or a McCarthyite, by a person whose skin is black or whose skin is white. The market is an impersonal mechanism that separates economic activities of individuals from their personal characteristics. It enables people to co-operate in the economic realm regardless of any differences of opinion or views or attitudes they may have in other areas.
-Milton Friedman
The great advantage of the market is that it is able to use the strength of self-interest to offset the weakness and partiality of benevolence, so that those who are unknown, unattractive, or unimportant, will have their wants served.
-Ronald Coase
Opportunity Cost
Opportunity cost is the value of your next best alternative. This applies to any choice you make but is best illustrated by comparing accounting profit to economic profit. Suppose you run a restaurant that makes you an accounting profit of $100,000. If your next best alternative was using the same capital to run a dry cleaner for a profit of $80,000, then we can say that your economic profit is your accounting profit ($100,000) minus your opportunity cost ($80,000) for a total of $20,000. That is how much “extra” profit you have made above and beyond your best alternative.
But suppose your next best alternative was not to run a dry cleaner, but to run a short-term rental business. And the accounting profit you could have received from running the short-term rental business is $120,000. Now your economic profit, accounting profit minus opportunity cost, has become a loss. You made $100,000 from running your restaurant, but you have lost $20,000 in choosing to run the restaurant rather than a short-term rental business.
Economic theory suggests that in a competitive market with free entry and exit, people are unlikely to continue in activities that generate economic losses. Or, put another way, people search for the best use of their time, energy, and money. None of us want to leave money on the table. People tend to move towards more valuable and productive activities and away from less valuable or less productive activity.
A few caveats: I am assuming ceteris paribus (“all else being equal”) in my example. Some things that I am holding constant across the restaurant – dry cleaner – short-term rental business include: how much time you spend running them, how much you enjoy running them, the same amount of money/capital invested in them, etc. It is quite possible, almost certain in fact, that owners work different hours in those three businesses, and operate with varying amounts of capital, and have different levels of enjoyment. Therefore, it would be surprising to see an identical rate of return / economic profit in all these (and every other) industries.
Instead, the different preferences of owners are reflected in the supply of people willing to run these businesses. Those businesses that are “more fun” or “easier” to run, ceteris paribus, will be more competitive because more people want to operate them, and therefore their profitability will be lower. In this case, the economic loss borne by the owners is compensated for by quality of life considerations.
This is also quite important for the labor market. For a job that provides roughly equal benefit to society (that is to say, the demand curve for workers in that job) is similar to another job, the pay will be higher, lower, or comparable depending largely on how pleasant or unpleasant people find the work, because the attractiveness of the job itself will affect how large or small the supply of workers in that field is. This phenomenon, known as “compensating differentials,” is extremely important when considering the efficiency of markets as well as assessing the significance of “market failures” like externalities. But that is worth a separate post.
Birth Rates
Birth rates have declined across industrialized countries. In the U. S., for example, the fertility rate (number of children born on average per woman) had a peak in 1957 of almost 3.6. Last year it was 1.778 – basically half the rate of 1957. By the way, the “replacement” fertility rate that results in a stable population is 2.1. Above that rate and a population will grow, below that rate and a population will shrink. The U. S. birthrate dropped below replacement in 1973. An obvious question, then, is: “Why are there so many more people living in the U. S. today than in 1973 if the fertility rate dropped below replacement?”
Immigration.
Ultimately, population growth in the U. S. has largely been sustained by immigration (legal and illegal) for the past half century. This creates many cultural and political challenges as I’m sure you are aware. These challenges are even more pronounced in Europe where birthrates have been lower for longer than in the U. S.
Consider the difference between countries with high fertility rates and low fertility rates. Ten countries have fertility rates above 5. They are all in Africa. New Zealand, the UK, Sweden, and the U. S. have similar fertility rates right around 1.8. According to the CIA factbook, they are 136th to 140th relative to other countries.
The five countries with the lowest fertility rates are: Hong Kong (1.22) , Macao, South Korea, Singapore, and Taiwan (1.07). All these countries have wealthy economies. I expect they share other important similarities too, but wealth is the factor I want to highlight when it comes to opportunity cost considerations.
Opportunity Cost and Plummeting Birth Rates
An important feature of opportunity cost is that it is relative – it involves comparing tradeoffs between what could be done or produced. Ironically, opportunity cost rises as we become more productive or effective at doing something. Consider this highly simplified illustration.
Imagine that with similar resources, time, and effort, you can produce either 1 boat or 1 car. In that case, the opportunity cost of producing 1 boat would be giving up producing 1 car, and vice versa.
Suppose that due to improvements in skill or technology, you improve in your ability to build cars such that, with the same resources and with the same amount of time, you can produce either 1 boat or 10 cars. You are much more effective at building cars than you used to be. Your opportunity costs have changed. If you take the time to produce 1 boat, you give up producing 10 cars. But for each car you produce, you give up producing 1/10 of a boat. It has become “cheaper” for you to produce cars and more “expensive” for you to produce boats, in terms of opportunity given up.
Suppose this trend continues and eventually, with similar resources and a similar amount of time, you can produce either 1 boat or 1000 cars. Producing boats has now become incredibly expensive in terms of how many cars you give up producing. You’ve become more efficient at producing cars, but the opportunity cost of producing boats has gone up dramatically.
Substitute “children” for boats and “salary,” “opportunities,” or “wealth” for cars, and you can see why birth rates around the world are plummeting. Living in NYC and teaching young women in college gives me a front row seat to this phenomenon. Colloquially this phenomenon is seen in how often conversations about career versus family come up. Misleading talks like “how to have it all” are also not uncommon in our culture.
High monetary opportunity costs also show up in parenting styles and decisions about how to spend one’s time. Why would someone who makes $500 or $1000+ an hour do their own grocery shopping? Or research and book plane tickets or dinner reservations or plan events or order gifts? The personal assistant or executive assistant epitomize the phenomenon of opportunity cost.
While that application may be innocuous enough, what about when considering: picking children up from school, watching them in the afternoon or evening hours, playing with, nurturing, and educating children? Many of my students nanny for people in the city and it is quite common to hear about families with both spouses working who may or may not see their children on a given day. Sometimes they will have nannies pick up their kid(s) from school, make them dinner, and put them to bed before either parent gets home.
Education also becomes an external service provided by someone else – and in classic human nature, parents want to equip their children to grow up to be like them – which involves training them to be productive too getting into the right university, which requires being in the right private schools and getting the right test scores.
The rapid rise of surrogacy, that is of paying women to bear your children, is another consequence of rising opportunity costs. Why give up a demanding (though high paying) job to go through the trials and difficulties of pregnancy when someone else is willing to do at a lower cost? Obviously ethical issues abound here, but the connection to opportunity costs should be obvious.
Other Important Considerations
The story I am telling here is intentionally over-simplified to illustrate the effect of changing opportunity costs. There are many other things we might want to work out in this puzzle. Economists distinguish Income Effects from Substitution Effects. I might buy more oranges because my income has risen; or I might buy more oranges because they have become cheaper relative to other (substitute) fruits.
Suppose that if I had $10 and the price of oranges and apples were both $1, I would buy four apples and six oranges. Now suppose that the price of apples increases to $2 per apple. I have become poorer in general (unless I were already spending all of my income on oranges). So the Income Effect would cause me to buy fewer apples and fewer oranges. However, the Substitution Effect would cause me to buy fewer apples because they have become relatively more expensive but more oranges because they have become relatively cheaper.
As a result, we can conclude with certainty that I will buy fewer apples than before because both the Income and the Substitution Effects work in that direction. But whether I buy more, the same, or fewer oranges will depend on the relative size of the Income Effect and the Substitution Effect. Any of these combinations of $2 apples and $1 oranges starting with an income of $10 is possible:
3 apples and 4 oranges (Income Effect > Substitution Effect)
2 apples and 6 oranges (Income Effect = Substitution Effect)
1 apple and 8 oranges (Income Effect < Substitution Effect)
The opportunity cost story I tell here is entirely focused on substitution effects; the relative cost of “producing” income versus children. But as people grow wealthier, their demand for children could increase – particularly if they view children as normal goods.
If we were to become so much more effective at producing cars relative to boats, we would expect the marginal market value of cars to decline while the marginal value of boats increases. I think we see evidence that people “value” children more in dollar terms than in the past. You can see this in how expenditures on children have generally risen precipitously, especially when it comes to education expenses. Also, people with higher incomes have become more concerned about “protecting” their children because of their relative scarcity. The death of a child is tragic, but I want to suggest that people tend to fear the death of a child more if they have one or two than if they have four, five, six, or more.
The tools of economics become a bit unwieldy the further we wade into this area, as value and love are related but not synonymous. Nor is market value the same as moral value. I am not suggesting that parents with fewer children love those children more in general. In fact, I would argue that in many cases people who choose to have fewer children tend to value them more in tangible market terms than in terms of moral value.
Obviously, people have diverse motives, and I am only speaking about tendencies – but it is not a coincidence that some communities have much higher birth rates than other communities. Where I live, if I see someone with four or more kids, I assume they are religious. Part of the reason we have had more kids is that we see intrinsic moral value in life, and in children, not value based upon what those children will accomplish. We wouldn’t be able to send five or more kids to private schools with tuition north of $20,000 a year.
For some people, that means they cannot afford to have more children because getting them in those schools, and eventually into elite universities and high-paying jobs, is unconsciously a large part of what makes those children important and successful in their eyes – and tragically often how the children come to value themselves (see Excellent Sheep for nice extended consideration of these dynamics).
Religious people tend to view things quite differently. Going back to the boat versus car analogy, it may be true that we have become much more efficient at producing cars relative to boats – causing the opportunity cost of boats (or children) to rise. But how we value those things can make a dramatic difference. What if we are talking about toy matchbox cars rather than passenger cars and luxury yachts rather than tiny sailboats.
In that case, a thousand fold increase in our ability to produce the cars may have a relatively negligible effect on our decision of whether to produce more cars relative to boats. Again, this is not an either/or story, but rather a matter of priority and how people make tradeoffs.
I haven’t even mentioned how existence and availability of contraceptive technology as opposed to abstention affects the costs of avoiding having children. Those who object to more or all forms of contraception on ethical or religious grounds face a very different calculation than those who have no objection to using many forms of contraception.
No doubt, on the margin we are all affected by changes in opportunity cost – but those marginal changes are much smaller for some people than for others based on what they value and believe.
For where you treasure is, there will your heart be too.
Talk to you next week!