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

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Economics Terms A-Z


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A tradeoff refers to a situation where 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 are all constantly facing tradeoffs in decisions we must make. For example, we’re considering tradeoffs when choosing between purchasing a new mobile phone or saving the money to pay for the next holiday. Or when deciding between staying up longer for drinks with friends or going home to rest before an exam. 

All of these situations are similar: no matter which decision we finally make, it will bring us closer to reaching one goal. But at the same time, it will make reaching another, competing goal harder. 

Let’s consider the first situation mentioned above to think about the tradeoff between saving and spending money.

The tradeoff 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 holiday. If you choose to 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 time it will become harder for you to reach the other goal.

It’s important to note that these goals must be competing to truly be considered tradeoffs. In this case, since both goals cost money, using your money to reach one of the goals makes it more difficult to reach the other goal because both draw from the same resource. Scarce resources like time and money tend to be the limiting factors for many decisions involving tradeoffs.

However, some decisions would not truly be considered tradeoffs. For example, suppose you decide to go to the park in the morning and watch a movie in the evening. There was not a tradeoff considered when reaching that decision, because neither event competed with the other for time, and both were free so they did not cost money. Instead, a tradeoff would be present if you considered going out to eat with friends instead of watching the movie.

Tradeoffs in the economy

Political decision-makers also face tradeoffs with decisions involving 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 equity (or equality) when designing a tax system. Most countries have a progressive income tax which means that people with higher incomes pay higher taxes. Policymakers, economists and the general public agree generally that the country’s tax system should be progressive to some extent. However, 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 economic profit from their increased effort. Therefore, efficiency would call for more moderate tax rates also on high incomes. 

At the same time, taxes are an important instrument of redistribution as tax money is used to finance public infrastructure and other goods and services. Hence, there exists a tradeoff between economic efficiency and social welfare.

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 analyze and quantify these tradeoffs and thereby help decision-makers to reach (evidence-based) decisions that improve welfare.  

In economic theory, tradeoffs 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 tradeoffs 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 tradeoff” 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. 

On the one hand, the capitalist system encourages people to economically do better than other members of the society. On the other hand, 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 well being.

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 modeling 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

The English proverb “you can’t have your cake and eat it too” summarizes the concept of a tradeoff. Keeping the cake and eating it are two incompatible goals. In other words, we simply cannot have it all.

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