Trade-Offs Research Paper - Research Paper Examples

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Given finite resources and limited productive capacity, economies are inevitably constrained with respect to their production and consumption options, particularly in the short run, and consequently must choose among alternatives. These constraints apply both to private individuals in the allocation of their budgets and to the government in its decisions over the provision and financing of public goods. By choosing to have more of one good, an economic agent must be willing to accept less of something else, thus defining a trade-off between the two alternatives. An important challenge facing economic decision makers is to allocate resources efficiently subject to the constraints imposed by the trade-offs they face.

At the aggregate economy-wide level, the constraints imposed by fully utilized finite resources can be represented by a production possibility curve. In his pioneering 1958 textbook Economics, Paul Samuleson described this in terms of the choice between “guns” and “butter.” An economy can have more butter only if it is willing to have fewer guns. The number of guns one forgoes in order to obtain an extra unit of butter is referred to as the “opportunity cost” of an extra unit of butter. Not only is this trade-off negative, but it is generally assumed to be concave with respect to the origin. This implies that each extra marginal unit of butter requires the economy to forgo increasing quantities of guns and is known as the law of increasing costs. This is a consequence of the economy’s factors of production being imperfect substitutes in the production of the two commodities. As resources are increasingly transferred from gun production to butter production, they are increasingly more suited for gun production and less efficient for producing butter.

The Phillips Curve

The concept of trade-offs is generic, and some of the most important trade-offs relate to policy making. Among the most celebrated is the so-called Phillips curve, named after the New Zealand economist A. W. Phillips. In 1958 Phillips used British data to find a pronounced negative relationship between the rate of unemployment and the rate of (wage) inflation. This was interpreted as confronting policy makers with a trade-off between inflation and economic activity. Introducing an expansionary fiscal policy to reduce unemployment, according to Phillips, will also raise inflation, forcing the policy makers to choose some combination of these two responses.

In the 1960s and 1970s, as economists scrutinized the unemployment-inflation relationship in more detail, the nature of the trade-off was questioned. First, with rising inflation during that period the Phillips curve appeared to be unstable, shifting out over time. Several authors, most notably Milton Friedman in his 1968 article “The Role of Monetary Policy” and Edmund Phelps in his 1967 article “Money-Wage Dynamics and Labor-Market Equilibrium,” argued that the Phillips curve should be augmented to include anticipated inflation. As a result the trade-off between current inflation and unemployment would still shift out over time as past inflation was increasingly incorporated in anticipated inflation. However, in the absence of “money illusion” (the tendency of people to evaluate their wages in nominal terms rather than in real terms), they argued that the trade-off was only temporary. In the long run expectations will be fully realized, and anticipated inflation will fully reflect actual inflation. Unemployment will converge to the “natural rate” of unemployment, a rate determined by the structural characteristics of the economy and independent of conventional monetary and fiscal policy instruments, so there is no long-run unemployment-inflation trade-off. The “rational expectations” revolution led to an even more drastic conclusion. If economic agents are smart and understand the structure of the economy, they will internalize government policy into their inflationary expectations and thus negate the trade-off even in the short run.

Other Types Of Trade-Offs

In contrast to the static (but possibility shifting) trade-offs associated with the Phillips curve, other trade-offs are fundamentally intertemporal or occur over time. The most basic of these is the relationship between investment and consumption. To increase current investment an economy needs to increase its current savings, and with fixed output this involves giving up current consumption. Over time, as the increase in investment augments the capital stock, the economy’s productive capacity is increased, thus increasing future consumption; the trade-off is therefore between current consumption and future consumption. In deciding on the intertemporal allocation of resources, an economic agent needs to weigh the short-run consumption losses against the long-run consumption gains.

By its nature investment is also risky and therefore is associated with another important trade-off, that between risk and return, a crucial element in financial decision making. Assuming agents are risk averse, the riskier an investment the higher its return will need to be to compensate the investor for the additional risk. This trade-off between risk and return is the basis for the pricing of risky assets and is central to the theory of corporate finance.

Trade-offs exist in other dimensions as well. Almost all economic decisions have differential effects on different segments of the economy. Some groups inevitably benefit more than others, who may often be adversely affected. This is particularly true of trade policy. A tariff designed to stimulate an import-competing industry, through its effect on the real exchange rate, will affect other sectors of the economy adversely, again giving rise to a trade-off in benefits, this time across industries. Moreover in the presence of externalities, the social opportunity cost may differ from the private opportunity cost, in which case the social and private trade-offs will diverge.

Finally, some trade-offs are more controversial. Some economists argue that devoting resources to improve environmental standards will harm the productive capacity of the economy, implying a trade-off between economic performance and environmental quality. Others argue precisely the opposite; devoting resources to the environment will stimulate employment, increase the efficiency of the economy’s productive inputs, and enhance economic performance, thus denying the presence of any trade-off in this case.

Bibliography:

Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review 58 (1): 1–17.
Phelps, Edmund S. 1967. Money-Wage Dynamics and Labor-Market Equilibrium. Journal of Political Economy 76: 678–711.
Phillips, A. W. 1958. The Relation between Unemployment and Money Wage Inflation in the United Kingdom, 1861–1957. Economica 25: 265–277.
Samuelson, Paul A. 1958. Economics: An Introductory Analysis. 4th ed. New York: McGraw-Hill.