Kestrel Island's Energy Investment: Opportunity Cost and the PPC
Kestrel Island has 180,000 residents and a single-year public investment budget of $240 million. Its electricity comes from imported diesel, costing $95 million a year and exposing households to volatile prices. The government is choosing between two projects. Project T is a tidal lagoon: capital cost $240 million, capacity 60 MW, construction five years, expected operating life 35 years, and it would create 300 construction jobs and 40 permanent jobs. Project G is a gas-fired plant: plant cost $150 million, grid reinforcement $45 million and an LNG import terminal $15 million, total $210 million; construction three years; operating life 25 years. The remaining $30 million would fund vocational training. Gas prices are expected to remain volatile. The island also has high youth unemployment and no existing engineering training centre. Local fishermen say the tidal barrage would alter sediment flows, though the effect is disputed. The finance ministry insists on comparing options using the same budget horizon.
1. Explain the opportunity cost of choosing Project T, and calculate it in terms of the alternative package.
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Opportunity cost is the value of the next best alternative forgone, not the money cost alone. If the government spends $240 million on the tidal lagoon, it cannot spend that $240 million on the gas package. The gas package costs $150m + $45m + $15m = $210m, leaving $30m for vocational training. Therefore the opportunity cost of Project T is the gas plant, grid reinforcement and LNG terminal plus the $30m vocational training programme. In money terms it is $240m, but in real-resource terms it is the electricity capacity, construction jobs and training places that the alternative would have provided. A stronger answer notes that the comparison must use the same time horizon: the tidal lagoon lasts 35 years and the gas plant 25 years, so simple capital-cost comparison is misleading. The relevant opportunity cost should be expressed as the present value of the alternative's output and training benefits over the same period. Also, the $95m annual diesel saving is a benefit of either project, so it should not be counted twice.
2. Assess which project is more likely to shift Kestrel Island's production possibility curve outward in the long run.
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A PPC shift outward requires an increase in the quantity or quality of factors of production, or better technology. The tidal lagoon may shift the PPC outward through several channels: it creates construction and permanent engineering jobs, it may support a new engineering training centre, and it reduces dependence on imported diesel, improving the current account and reducing exposure to price shocks. Renewable capacity may also attract investment. However, the five-year construction period delays these effects, and the sediment dispute could impose external costs on fishing, which would reduce output elsewhere. The gas plant shifts the PPC outward sooner because construction is three years and the technology is proven. The $30m vocational training package directly improves human capital, which is a clear PPC shifter. But gas exposes the island to volatile fuel prices and does not build a new skill base. The decision therefore depends on the time horizon and on whether the fishing externality is real. If the government weights long-run productive capacity, the tidal package is more likely to shift the PPC outward; if it weights quick recovery and low risk, the gas package is stronger.
3. A minister says: 'The tidal lagoon is free because the sea is a natural resource.' Evaluate this statement using economic ideas.
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The statement confuses a free natural resource with a free good. The sea may be non-excludable in some uses, but the lagoon still requires scarce capital, labour, engineering skills and construction materials. Those resources have alternative uses, so the project has a positive opportunity cost. The minister is also ignoring external costs: changing sediment flows may reduce fishing output, and that loss is a cost even if no one pays for the sea. If the sea is common property, there is a risk of overuse or unregulated damage, which is a market failure rather than evidence of zero cost. A correct economic statement would be that the sea itself may have no market price, but the project uses scarce resources and may impose external costs. The government should compare the present value of benefits - avoided diesel imports, reliable electricity, jobs and possible fishing losses - with the present value of costs, including the forgone training programme. 'Free' is therefore wrong unless all opportunity costs and externalities are zero, which they are not.