Fancy Pants Economics

"No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be. . ."
-Isaac Asimov

The problem with Economics is most people have absolutely no exposure to it unless they were unfortunate to be forced to take an introductory class by their academic department. In an effort to legitimize themselves economist are quick to bust out phrases like quantitative easing, money multipliers and efficient frontiers. This is an excellent way to put your audience to sleep before you even get started; thus easing the pressure to actually say something of value since the given audience is already sleeping and won't hear what you are saying anyway. Unfortunately there is not much communication between the the economic "in" crowd (a very popular well-liked bunch) and your everyday Joe. Despite the fact that most of the decisions you will make are inevitably tied to your financial situation, most people have never considered the process by which they make their decisions. Throughout the next few paragraphs, we are going to explore in everyday language, the theories behind the way economists view the way people make decisions.

For starters we must acknowledge that this is obviously a very difficult task. To put into words and testable theories the way people make decisions is an inexact science and each has plenty of flaws and exceptions. The basic premise behind the way someone makes a decision is describe as opportunity cost. Most basically opportunity cost is the value of the next best alternative foregone as the result of making a decision. This is a complicated way to say the cost of spending $1,000 is the next best thing you could have done with that $1,000. For example the "opportunity cost" of buying $1,000 worth of stock is that you cannot invest that stock in a CD and earn a guaranteed 3.5%. It is important to note that opportunity cost is subjective and varies from person to person (resulting in people making different decisions given the same set of choices). For someone who is out shopping for a prom dress, the opportunity cost of buying the red dress is the resulting situation that you cannot buy the blue dress that was your second favorite item. A good way to think it through in your head is if you don't make X decision with your dollar what would you do with it instead? The cost of buying X item is, you cannot do Y with your money. This is an important concept to understand when evaluating financial decisions you face on a daily basis. Always think to yourself. If I don't make this purchase what will I do?

Economists also make another very big assumption when considering the way people make decisions. They assume that every person given a set of choices will choose the option that maximizes their happiness (expressed as utilities in economic lingo). It can be proven time and time again that people do not always choose the option that maximizes their happiness so what gives? There is a lot of debate in the field but my personal take on it is the majority of the "irrational" decisions people make is a result on imperfect information. There are also a lot of non quantifiable variables that go into a decision that cannot be expressed in a simple algebraic equation.

Lets take ourselves through a real world example of this:

Suppose you were in a a bookstore with a $20 gift card.

You are faced with the task of picking out the book that will "maximize your happiness." According to economic theory you would go through the process figuring out all the books in the store that were priced at or under $20 and picking the one that you would like the best. In the real world you don't know every single book in the store and what's more you don't know what book you will like the most without reading it first. Theoretically though you will go to your favorite section and narrow it down to your two choices. Go Dogs Go and Green Eggs and Ham. You choose Go Dogs Go because nothing in the entire store would make you happier than owning Go Dogs Go. The opportunity cost of getting Go Dogs Go is the fact that you cannot have Green Eggs and Ham. But wait, now lets throw a kink in the system and suppose that you can sell your gift card back to the book store for $15 in cash. Now you take the cash and go buy a copy of the newest Gwen Stephani CD because the satisfaction you get out of playing the CD in the car and annoying the rest of your family far exceeds the fact that you have to pay $15 dollars for it, not to mention, even to you, Gwen Stephani is mildly annoying.

This is how irregularities can occur when evaluating the way people make decisions. When you know that a person does not like Gwen Stephani but yet they spend $15 on her CD it does not make any sense but the part of the equation that is left out is the fact that the person does not actually enjoy the Gwen Stephani CD but rather they enjoy watching the torture it causes everyone else who is forced to listen to it. Another example would be the fact that people will pay five times the price for something that is name brand. The satisfaction you get out of showing that you have the money to buy a Polo shirt is greater than the $75 difference between a polo and your basic collard shirt sold at Wal-Mart.

To avoid a situation where you are making a decision based on imperfect information it is very important you gather as much information as possible and make sure you are considering ALL of your options. For example when you are at a car dealership looking for a car under $20,0000 and the dealer presents you with two options. For simplicity, lets make a very BOLD assumption and say you actually HAVE the 20k in cash to pay for the car. You are not simply deciding whether you want a red Honda or a black Toyota; you have to consider what you are losing by making that decision (e.g., you could take your 20k spend $1000 on a baller Ford Taurus and put the other $19,000 in the bank, quit your job and travel South America for six months).

Money is just a way of keeping score and a logical way to communicate the value someone else has placed on an item in terms you can understand. It helps create liquidity between a seller and a buyer, but how do we put a real value on it? If someone asked you what $1 dollar was worth, how would you respond?

TRC