FOOL ON THE HILL
Four Economic Concepts You Should Know

The new science of behavioral economics is growing, but investors also need an understanding of basic traditional economic concepts such as opportunity cost, rational decision-making, and the cost of information. Traditional economics gives investors powerful tools for understanding how people make buying choices.

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By Richard McCaffery (TMF Gibson)
May 3, 2001

University of California-Berkeley economist Matthew Rabin Friday won the prestigious John Bates Clark Medal, awarded every two years to an influential economist under the age of 40.

As The Wall Street Journal reported, Rabin won the award for his studies into topics such as procrastination and drug addiction, and how they impact the way we make choices. This is what economics is all about, understanding how people make choices. Why, for example, do people buy one product instead of another?

The Journal has written a number of stories about young economists in contention for the Clark medal, and how their unique views are stirring up the study of economics. And much has been written in the business press -- even here at The Motley Fool -- about the new field of behavioral economics, pioneered by University of Chicago economist Richard Thaler. The idea is that people don't make choices quite as rationally as economists traditionally believed. Psychology, Thaler argues, plays a role.

Traditional economics, for example, says $1 is $1 and consumers will value it as such. Yet economists such as Thaler argue this isn't necessarily so. A person may treat $1 won in a poker game very differently than $1 earned on the job, even though it's worth the same amount. This is not the kind of behavior traditional economists expect, in the aggregate, from rational consumers. Nevertheless, there are plenty of examples of similar behavior.

This may not sound like much of a lightning bolt, but it's a departure from the ground economists usually tread. The trouble is, it's hard to understand how behavioral economics fits into the machine unless you know the basics of traditional economics, which offers a very powerful and flexible way of thinking about the way we make choices.

For my part, psychology clearly plays a role in our decision making. What's not so clear to me is that basic economics isn't flexible enough to account for many of the anomalies behaviorists point out.

The good news is that it doesn't take much to learn the basics; just open up an in introductory economics book. My thanks to James Gwartney and Richard Stroup, authors of Economics: Private and Public Choice, a economics text that lays it on the table in chapter one. Right away they give us the basic principals that shape the way economists think. I've pulled out the few I think are most valuable for investors.

By the way, this is the course of action suggested by Berkshire Hathaway (NYSE: BRK.A) Vice Chairman Charlie Munger for folks who want to improve the way they make decisions. Learn a few of the basics in many fields, from economics to psychology, then practice applying the basics when solving problems. Do it often enough and you'll have multiple ways to problem-solve. If you're an economist, therefore, you wouldn't have to look at a problem from the same hilltop as your fellow economists. You would have stood on many hilltops by then, and you'd have a problem-solving box stocked with tools picked up during the journey. 

Economics 101
1. Opportunity cost: This is critical for investors. You can't understand the full cost of a good or service just by reading the pricetag. Its full, or economic, cost includes the value of the opportunity lost. So if you decide to read a book tonight, the opportunity cost involves the cost of the most valuable option lost, whether it's playing with your kids, painting a door, or sleeping.

This isn't just nerdy textbook stuff, since opportunity cost colors our expectations. For an investor with finite capital, the cost of buying a stock isn't merely the price paid for the security. The cost must be weighed against other investing alternatives, and this shapes the expectations we have for the stocks in our portfolios. In other words, in return for the risk of investing in a given stock, I'm going to expect a return at least as good as I can get in other stocks with similar risk characteristics, and better than I can get investing in a risk-free government security.

That's why, as we often hear investors say, the cost of equity -- incurred when a company sells stock to the public -- is more expensive than debt. Intuitively this may not make sense. After all, debt is money you have to pay back with interest. But investors who bought the newly minted equity expect an appropriate return, and if it doesn't materialize they will sell their shares.

If you still think that equity-funded capital was free, wait until the next time the company has to raise money; companies almost always need access to money for basic working capital costs or expansion. Having failed to generate the return investors expected, the company may not be able to raise money in the public markets again. In this case, the cost of equity capital has gone from "free" to "unavailable."

And there are myriad secondary effects for a company in this position. If the company's stock has plunged, what about the drumbeat of daily news stories regarding its failure to earn a satisfactory return? What effect will this have on the company's employees, its stock option plan, compensation costs, investment bankers who might be willing to sell the company's bonds, or banks that might extend a line of credit? 

2. Rational decision-making: This basic tenet says consumers think hard about how they spend money, time, and other resources, and try hard not to squander what's in scarce supply. It's called economizing behavior, and it means we make choices based on opportunities that will provide us the greatest benefit at the lowest cost.

This may sound simple -- and perhaps it over-reaches in that other factors play an interesting role -- but it allows you to predict the outcome of a great many transactions. Which coat will you buy: the least expensive, the best-looking, or the one that provides the greatest benefit at the lowest cost? This axiom sounds trite only because this type of thinking is integrated so well into our decision-making process.

At the same time, rational decision making is a chink in the armor for behavioral economists looking for a point of attack on traditional economic theory. There are plenty of anecdotes from behaviorists that illustrate how consumers don't always make rational decisions.

One of Richard Thaler's experiments: Imagine you're stuck on a beach and a friend offers to buy you a beer in town. Why should you be willing to spend more for a Budweiser purchased at a fancy restaurant than at a little grocery store? Yet in Thaler's experiment, people are willing to pay more for the same beer if they're told it's being purchased at the fancy restaurant. Why should this kind of irrationality exist?

3. Information sparkles, but it's hard to acquire: This is a gem if we understand its implications. It informs us that there's a cost -- in large part the time involved -- associated with obtaining the information we use in making choices. Thus, almost every decision we make will be based on the limited information we can gather given the cost and our ability or willingness to meet it. Our information will always be imperfect and incomplete.  

How true this is with investing -- and what a clamor of information investors hear today! How do we obtain the most valuable information regarding, say, retail stocks, at a cost low enough so that we can make an informed decision, either buying a stock or walking away for good reason?

There's no pat answer, but mapping out a plan based on the need for information, an understanding of its cost, and the reality that decisions are made without perfect data is a useful way to frame the exercise.

4. The value of goods and services is subjective: This is true for two people, who may value a given product differently, but also for the same person, who may value a product differently as his circumstances change. How much would you pay for a bottle of water after a tough tennis match? How much would you pay for the same bottle of water if you just bought a case that's sitting at home in the refrigerator?

Entrepreneurs, Gwartney and Stroup tell us, are skilled at understanding what products consumers will value under a given set of circumstances, and at marshalling ways to get those products into consumers' hands.

Just an understanding of the basics -- opportunity cost, rational decision making, the cost and limits of information, and the subjectivity of value -- can give you a better understanding of how you make choices, and how economists think about them. Not only that, it gives you a starting point for understanding the new soil being tilled by behavioral economists today.

Have a great day.
 
Richard McCaffery loves old-time hockey. His stock holdings can be viewed online, as can the Motley Fool's disclosure policy.