Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Tradeoff

A tradeoff refers to a situation in which in order to come closer to reaching one objective you must sacrifice another. In other words, when people or societies are facing a tradeoff, two or more goals are at odds and cannot be satisfied simultaneously. Any progress towards one of the goals is (at least partially) offset by a deterioration of the prospects of reaching another goal.

We all are constantly facing tradeoffs in decisions we must take. For example, should we stay up longer and have another drink with our friends or go home to get a good night´s rest and study for our next exam? Should we buy a new mobile phone or save the money for our next holiday? Should we move to the countryside or stay in the city? Should we go to work and risk being infected by a contagious disease or should we stay home and risk being laid off?  

All of these situations are similar in no matter which decision we finally take it will bring us closer to reaching one goal, but at the same time make the reaching of another harder. Let us take the second of the questions from above to think about the tradeoff between saving and spending money. Most of us are saving part of our income for future purchases, like a car, a house, a special holiday or an unexpected expense such as a broken washing machine. Let us assume that you were saving up to go on a special holiday e.g. a trip to Antarctica. At the same time, you also want to replace your old mobile phone by a new one. Now the tradeoff that you face is the following: If you decide to buy the new phone you will have to use some of your savings that were reserved for your trip to Antarctica. If you decide not to buy the phone but save the money for the trip you will have to use your old mobile phone. Clearly, no matter what you decide, you will come closer to one goal (having a new phone or going on a special vacation), but at the same it will become harder for you to reach the other goal.

Political decision-makers also face tradeoffs when they decide between different economic policies. One central tradeoff in economics is the one between efficiency and equality (or equity). Economists overall tend to agree that the market does a pretty good job in assigning scarce resources efficiently, but less so when considerations of justice or fairness are taken into account as well. Therefore, redistribution plays a central role in most countries and taxes are a key instrument to reach redistributional goals. So, let's think about the tradeoff between efficiency and equality when designing a tax system. Most countries have a progressive income tax which means that people with higher incomes pay higher taxes. While there is widespread consensus among policymakers, economists and the general public that the country’s tax system should be progressive to some extent, there is a lot of debate concerning the exact income thresholds for each tax rate and how high the different tax rates should be. Some fear that excessively high tax rates for high incomes will harm the incentives of high-income earners to work and innovate. This stems from the idea that people are motivated by incentives and only work hard if they expect higher financial gains. Therefore, efficiency would call for more moderate tax rates also on high incomes. At the same time taxes are an important instrument of redistribution from richer and more privileged households to poorer households as tax money is used to finance public schools, hospitals, infrastructure and transport, and other goods and services. Hence, there exists a trade-off between efficiency and social equality.

Other notable 'tradeoffs' economists consider are: the increase in budget deficit that comes from increasing government spending to stimulate investment, and the disincentive to work that comes from raising unemployment benefits. Consequently, one of the main tasks of economists is to provide empirical evidence and theoretical models that analyse and quantify these tradeoffs and thereby help decision-makers to reach (evidence-based) decisions that improve welfare.  

In economics, trade-offs are measured using the concept of opportunity costs. Opportunity costs measure the costs of the best foregone alternative, i.e., it measures what we sacrifice in order to get something. You see that the concepts of trade-off and opportunity costs are closely related. The first describes the general problem of facing incompatible goals, while the second quantifies the costs of choosing one objective over another.

Further reading

In 1974 Arthur Okun’s book “Equality and efficiency – the big trade-off” was published. In this book the famous macroeconomist, who is better known for Okun’s Law, writes about the great tradeoff between equality and efficiency. The capitalist system encourages to economically do better than other members of the society, while social norms and values emphasize the importance of social equality and consideration of others who may be less fortunate. This contradictory message asks for an egalitarian social system while at the same time fostering increased inequalities in economic wellbeing.

In an empirical investigation published roughly at the same time as Okun’s book,  Browning and Johnson assess the social costs of redistributional measures (“The trade-off between equality and efficiency”, Journal of Political Economy, 1976). The authors estimate the marginal cost of reducing income inequality and find that this cost is quite high. Depending on the modelling framework they estimate that the disposable income of upper-income quintiles decreases by $3.49 - 9.51 for each dollar increase in the disposable income of lower- income quintiles.

Good to know

You probably have heard the English proverb “You can’t have your cake and eat it too”. Why not? Well either you keep the cake, or you eat it. Once it's eaten, it's gone. Hence, keeping the cake and eating it are two incompatible goals. Hence, whenever you hear someone using this phrase, you know that the person he or she is talking to is currently facing a tradeoff. Put differently, what the proverb as well as the term tradeoff are trying to tell us is that we just cannot have it all.