Yes. This has been the latest in our series “Short Answers to Misconceived Questions”.
Actually, there’s a longer answer over the fold, another extract from my book-in-progress Economics in Two Lessons. You can find a draft of the opening sections here.
This extract is a subsection of Part 2, in which I explore the implications of Lesson 1:
Market prices reflect and determine opportunity costs faced by consumers and producers.
The conclusion is
if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced.
I’ll be interested to see whether readers’ reaction is “That’s obvious” or “That’s obviously wrong”, assuming of course that you have any reaction at all. As always, civil comments of all kinds are welcome, particularly constructive criticism.
Natural disasters like floods, earthquakes and hurricanes come seemingly out of nowhere, wreak intense havoc in a short period, and move on, leaving vast, and largely random, destruction in their wake. Reports of such events commonly provide estimates of the associated damage bill. [1] The cost is partially covered by insurance claims and government disaster assistance, but inevitably much of it falls on the residents of the area hit by the disaster.
It is only natural for people, faced with such disasters, to seek to find some consolatory ‘silver lining’, and one such consolation is the idea that natural disasters will create work, and thereby stimulate the economy. Disasters certainly create work for emergency services of all kinds when they occur and for all the many kinds of workers needed to rebuild damaged houses and infrastructure.
The wages earned by these workers might be seen as an offset against the damage from the disaster. That would be true if they had nothing else to do. But, most of the time, such workers are not to be found sitting idle and waiting for a disaster to happen.
Government budgets are chronically tight, so emergency services are routinely overstretched. Providing additional services to respond to a disaster comes with an opportunity cost, that of the more routine services that would ordinarily be provided.
Similarly, unless the disaster happens to coincide with a slump in the construction industry, rebuilding damaged houses comes at the expense of the new houses that would otherwise have been built.
Lesson 1 tells us that, when markets are working well, the opportunity cost of the resources used in disaster recovery and rebuilding can be measured by their market value, that is the price paid for materials and the wages paid to workers. So, if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced.
Much of Hazlitt’s Economics in One Lesson consists simply of restating this application of Lesson 1 in a variety of contexts, from the broken window in the glazier story to the massive destruction wrought by World War II. In all these cases, assuming that markets are initially working well, the effect of unexpected destruction is simply to divert resources from new production to damage repair.
Lesson 2 shows that the proviso ‘when markets are working well’ is critical, and that Hazlitt’s argument must be heavily qualified as a result. In the presence (all too frequent in market economies) of mass unemployment, wages are not a good measure of opportunity cost. In these situations, events that create work may yield positive benefits. But natural disasters strike at random, and most of the time do not coincide with any requirement to create jobs in the construction sector. Moreover, there are many more useful ways of creating jobs. So, in economic terms, disasters are, in most cases, just as bad as they appear at first sight.
?
[1] Footnote These measures usually don’t take account of injury and loss of life, which may often be more significant. We will be discussing this issue later.
John Quiggin 
I agree. It seems very obvious. Is this a trick post to get rubes like me to agree and then prove us wrong? 😉
If there is large underutilised capacity in the economy (unemployment and idle plant) then a spending boost to address the disaster via a larger budget deficit might be beneficial in some ways. But I suspect disaster recovery and repair is a cycle that is too short to employ and train unskilled workers so it will fall to the current workers (taking them away from other tasks).
Even if GDP gets a boost from more activity, say to repair $1 billion of damage, the result at the end of that, all other things being equal, is that total national assets, public and private, show no increase for that extra billion spending. It’s got to be a loss.
Now if a natural disaster could selectively destroy pubs and racetracks and leave schools intact then this indeed would be a bonus to society.
I agree.
I found the extract a little confusing on first reading, below is not a suggested edit but my understanding of what is meant.
if the damage bill measures the cost of restoring assets to their pre-disaster condition [i.e. excluding the loss of production from those damaged assets], it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced from the resources used to repair the assets.
Often enough damaged assets are not worth restoring or replacing because they were a malinvestment to start with or because economic conditions have changed since being built so as to reduce their value. In such circumstances the cost of the disaster is less than the cost of restoration, but only if the assets are not restored.
John Quiggin,
My preliminary thoughts are that I hope in the chapter you cover human-environment interactions that cause or increase the likelihood of “natural” disasters, like climate change of course as you are part of the climate change authority, but also other things like soil degradation.
If you are still looking for examples, the Lisbon earthquake of 1755 is a good one, as it is used by Voltaire and Rousseau and others and is a turning point or paradigm shift in Western thought away from the understanding of natural disasters as Judgements of God.
That was in the Modern period and Enlightenment era, so it is the era of humans using knowledge of nature to try to control nature and use it for their own ends.
But due to this we now have all these mounting environmental problems, as nature was not understood to a sufficient degree and with enough complexity.
I think Goethe’s story of the Sorcerer’s Apprentice is good for this, as everyone just about has read it or at least watched Fantasia and knows how the Soreceror’s Apprentice can’t wield enough control of the magic over the brooms and so on. Of course Goethe treated this issue more seriously in Faust, but that is not such a good example for communicating with the public.
It occurs to me that a natural disaster could be either one or the other depending on the rebuilding. If we are returning to the status quo anti disaster (cladi if google trans and my declensions are holding up) then it is a cost. If it allows for modernization and rationalization of infrastructure, more engergy efficiency, and whateve then it is a mulitplier (probably not the correct term).
In one sense I am arguing the opposite of Stockingrate. If formerly existing assets are “replaced” with better assests then it is a gain. Heck even slum clearance might pay off.
The rebuilding of Christchurch after the earthquake of 2011 gave a measurable boost to the NZ economy, as it, especially the construction sector, has been previously travelling below capacity.
If the natural disaster clears away a ‘white elephant’ that we are sorry we built in the first place, but somehow we can’t seem to get rid of, then rebuilding might have some compensating benefits. I reckon the Sydney Opera House is an example; it is simply not imposing enough, and we learnt a lot during the process of building it. We would do it differently next time. Another example is the many telephone exchanges built in Australia not designed to accommodate newer smaller technology.
In any case where we have learnt how to build things more efficiently over time, like bridges, then the new bridge to replace a destroyed one would cost less to build. (But the cost of cleaning up the mess should also be factored in.)
If it is a destroyed atomic power station then we would almost certainly prefer that it was deconstructed more carefully. We lose many opportunities in the disaster from polluted farm lands and living space we can’t use. We would not choose to build another one that was equally vulnerable.
On the other hand, if the natural disaster destroys a unique and irreplaceable artifact, then the loss is priceless.
JQ, my preliminary reaction to the ‘opportunity cost’ project, Lesson 1 and Lesson 2 is similar to my reaction to much of my undergraduate studies in micro and macro economics. The fact that I did pass all examinations very well did not negate my convinction that nothing made sense. Let me illustrate.
“if the damage bill measures the cost of restoring assets to their pre-disaster condition, it is also equal to the opportunity cost of the disaster, namely the goods and services that would otherwise have been produced”
What exactly are we talking about in the above quote? Is the cost of ‘restoring assets to their pre-disaster condition’ technologically feasible (not necessarily – think of antiques)? Is the cost measured in monetary units or in utilities? What is the ‘cost’ of goods and services that would otherwise have been produced if nobody wants them?
I am left with a notion of opportunity cost defined on at least two unknowns as described by my questions.
I am glad I’ve never come across Hazlitt’s Economics in One Lesson. I assume you have a specific audience in mind for your Economics in Two Lessons.
@Ernestine Gross
One is not to mention words like “emperor” or “no clothes”
@Ernestine Gross
Yes …
Most good graduates are in this boat …
They then enter industry, government, journalism (and even unions) full of this university economics causing all the long-run inequality and havoc we see about us today.
Disasters cost the forgone production. When an economy is at capacity, the forgone production is large and when it is under-utilised the forgone production is small. Makes sense to me. The cost will never be negative (a benefit) because even in a depression public works program could put unused workers to better use (adding to the capital stock) rather than rebuilding to the capital stock.
@Ivor
No., your story doesn’t match with my experience. Perhaps it would help if I were to clarify why ‘nothing made sense’. There were too many loose ends in the material. For example, the separation of microeconomics from macroeconomics made no sense to me. Macroeconomics was said to pertain to ‘the economy as a whole’. But surely, I thought, the whole without the agents studied in microeconomics results in a hole rather than a whole. Unbeknown to me at the time, I was searching for a systems approach to economics, which includes the natural as well as the institutional environment(s) at least on the basic conceptual level such that the distinction between micro- and macroeconomics becomes meaningless, but the institutional environment becomes a unit of analysis. Thanks to a Professor known in the policy area, I was passed on to a math economist. Economics became interesting. No more loose ends but many unresolved questions. And this is good so.
JQ,
in the meantime I found an e-copy of Henry Hazlitt’s Economics in One Lesson, and I read the Wiki entry on Henry Hazlitt, various entries on ‘opportunity cost’ and your draft of the Two Lessons you linked to. The latter has progressed a lot since I last had a look.
My personal preferences (an ordering of all alternative usages of my (finite life) time), my technology and my information set are such that I only skim-read Hazlitt’s One Lesson before deciding to close the site.
I tried to ‘apply’ the notion of ‘opportunity cost’ to the foregoing sentence, which describes my decision making process. I reached the conclusion this notion is at best a derived or secondary concept and as such it is not central for Economics, not even in the narrowest sense of this field of inquiry, namely naïve market economics. I used the description of the notion of ‘opportunity cost’ common to all entries I found, namely the ‘cost of the most highly valued alternative to the chosen option’. Clearly, knowledge of alternatives and a ranking of these alternatives according to some criterion is a precondition for applying the words ‘opportunity costs’ to describe a situation in real time. However, for reasons stated later on, reworking known results using the notion of ‘opportunity costs’ could reach a wider audience.
I could not find the term ‘opportunity cost’ in Hazlitt’s Economics in One Lesson, 1946
It seems to me JQ, your book, is dealing with the most difficult of all problems in education in Economics. Everybody is a member of ‘the economy’ (and therefore everybody needs some kind of mental model of ‘the economy’ to function) but only a tiny number of the members of ‘the Economy’ are interested in Economics as a field of academic inquiry.
IMO, Hazlitt’s Economics in One Lesson is an example of how a verbally skilled non-economist writes down his observations and conclusions, using the method known as verbal theorising without testable content. According to his own mental model, he would have done it because it was profitable for him. After all, writing was his production technology and the profit motive is crucial in his narrative.
I can see why some of his sentences ring true to many people from various walks of life even today. (For example, the Austrian verbal exposition of the implications of supply and demand changes for business profitability, repeated by Hazlitt, is still meaningful to business people other than corporate players of strategic games). I assume your book aims at the same audience to raise some doubts in their mind about the grand narrative, peppered with casual observations, in Economics in One Lesson. If so, then, in a sense, all comments about loose ends become out of place.
In reply to your invitation for comments:
You write: “Assuming that market prices are equal to opportunity costs, government interventions that change the market allocation must have opportunity costs that exceed their benefits.”
I do not understand. However, I would understand the sentence: Government intervention cannot improve on a market allocation if opportunity costs are zero. This would amount to characterising a Pareto Efficient allocation for a complete market model of a competitive private ownership economy in terms of opportunity costs for each agent in the economy. (Yes, for some readers Lesson 2 would be obvious but not to those who believe the notion of ‘opportunity costs’ is critical in Economics).
Question: Do you need to refer to mathematical economics at all in your book? As it stands, your draft of Two Lessons suggests that nothing has been learned from this work since 1946 and the topic is still ‘free markets vs Keynesian’. I find it hard to believe this is your opinion or a suggestion you wish to convey.
I have been wondering about this but without any form background in economics my curiosity was stimulated by three events to which I have a vague connection.
The first one was the earthquake that Haiti in 2010 devastating the population and their meagre infrastructure leaving about 200k people homeless. The second event was the even bigger earthquake and tsunami that hit Chile a month later (which is where I was born and having relatives living all over the country) and wiping out about 19% of GDP in about half an hour. The third event was the tsunami that hit northern Japan (Miyagi prefecture) in March 2011 (where I have friends who were originally from that prefecture and having worked in Japan as well).
I have little personal knowledge on Haiti – just basically what is published in the media and through Medicin Sans Frontiers but IIRC about two years ago there were still about 100k more or less homeless. Chile’s stock market and GDP had fully recovered. In Japan they are still rebuilding but it took them about 6 weeks to repair the main highway connecting Miyagi with the the rest of Honshu.
In Chile’s devastation the main (and only) highway connecting the south to the capital was destroyed (as well as the railway line). Some people have suggested that white elephants would not be replaced but in this case the white elephants would have been rather small and the ability for commerce were severely hampered. The immediate need for labour was huge. As an example many buildings were precariously left standing and these had to be demolished within hours without hampering rescue efforts. This meant that qualified staff had to be brought in from the northern half of the country thus in effect leaving their normal work frozen (the military transported them across). The construction industry sucked employees from the northern half of the country by offering higher wages to qualified staff. All up it took about three years for things to return to a new normal. Most of the public infrastructure had been built to standard but in this instance the standards were insufficient so I am not sure what the outcome was regarding insurance pay out. Private homes were uninsured and many were simply poor stock of housing due to the fact that Chile remains a poor country. Regarding insurance in Chile it is expensive as well as limited because Chile is an earthquake prone country. I recall investigating the cost of domestic insurance and it turns out that the cost is so expensive it was about 150% of the average monthly net salary and it came with the condition that there is no pay out if the earthquake is beyond a certain magnitude (or below another threshold) and the house has to be certified annually (at your additional expense) by an insurance company surveyor.
In Japan the reconstruction has been hampered by the loss of the nuclear power but as I understand it most of Honshu has been rebuilt. And I am led to believe that the insurance is also unaffordable by the average person.
In Chile’s case the rise in salaries and labour shifting has had lasting repercussions – as I said a new normal was established. Regarding costs reflecting the market value – I am not sure on that because the new infrastructure has been built to a higher standard than previously, hence the cost is higher and this may be reflected in the inflation figures but are we really comparing the same things?
Haiti fits into the picture because that country has not been able to recover as well as Chile or Japan. One possible explanation is that once a country reaches a certain level of wealth it is easier to rebuild. This also assumes that loss of life is relatively small but what happens if that is not the case?
Very interesting piece. I would like to mention an other “indirect” effect of the “restoring assets” process, when markets are NOT working well. In a context characterised by frictions in credit markets, insurance claims and government disaster assistance may also raise the liquidity of relatively wealthy, but not necessarily liquid households. Since the households receive funds upfront, in principle they could use the cash to finance current consumption expenditure, against lower consumption in the future. Here (bit.ly/1TyOCcO ) you can find a piece – that my co-authors and I wrote – where we show that the consumption by owner-occupiers responds quite strongly.