Decisions Have An Opportunity Cost That Require Tradeoffs

Opportunity Cost: A $10 Million Trade-off

by Elaine Schwartz    •    Aug 22, 2013    •    673 Views

NYC’s $69 billion budget is all about trade-offs.

With $10 million NYC could buy 9 ladder trucks for its fire department or pay 80 police officers a year. It could also resurface 65 lane-miles of city streets or it could just return $4.47 to each person paying a personal income tax.

These are the spending decisions that NYC has made for its 2013 $69 billion budget:

Opportunity Cost NYC budget

From: NYC Independent Budget Office

Let’s go for a moment to the pension slice in NYC’s budget pie because it differs slightly from the rest. Realizing that 9 ladder trucks are $10 million, we know we cannot spend that same $10 million elsewhere. However, because pension obligations require money that will be paid to city workers in the future, we cannot be positive how much to set aside now. Consequently, we cannot know the trade-off.

Investment earnings from pension funds are the source of more than 2/3 of retirees’ benefits. Let’s assume, for example, that we put $100 into our pension fund and need $8 to pay future retirees. Projecting an 8% return–the actual investment return assumption among most US cities–would mean we are adequately funded. If though, the return is 4% (and it really has been close to 6.3%), then you would have had to place $200 in the pension fund or you will not have invested enough to get the $8 you need.

The WSJ tells us that the average projected rate of return for public pension funds is 7.75%. However, a fiscally conservative Washington D.C. has lowered its anticipated return to below 7%.

You can see below which cities and states will have more of a trade-off than they planned for:

From: Pew Research

From: Pew Research

As economists, we can say municipal finance is all about opportunity cost. The alternative that is sacrificed, the opportunity cost of a spending decision means you cannot use that same money elsewhere. When pension obligations rise because of underfunding, there is even more of an opportunity cost. A higher opportunity cost means less money to spend on education, street lights and other necessities.

Sources and resources: Ideal for detail, this municipal finance study from Pew Research is excellent. For additional information on NYC’s budget, you can go to a reader friendly website with a wonderfully clear, brief and yet substantive description of their spending and revenue. If you would like to check out state “pension tension,” econlife discussed the issues here. Finally, discussing municipal finance in an article (pay wall) on Detroit, the WSJ conveys a good reality check.

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