Economics and You

Many people find the study of economics intimidating. The very term suggests endless streams of statistical data, along with formulas, charts, tables, and ongoing attempts to synthesize and extract useful conclusions that apply to everyday situations. Economists are often seen as modern-day fortune tellers. As one joke goes, it takes two economists to replace a light bulb -- one to change the bulb, and one to forecast how long it will last.

No matter how arcane the science of economics may seem, everyone uses economics in their daily lives. In its original sense, economics refers simply to how you manage your personal affairs. So whether you consciously think about it or not, everyone continually engages in economic analysis in helping to make decisions.

Basic economics
At the most basic level, each of us makes decisions about how to earn and spend money. For many, the supply of money is more or less fixed -- while one might get a raise from time to time or change employers to earn more, it often takes a significant investment of time and money to amass the education or training necessary to change to a higher-paying profession. Otherwise, given a particular income, we focus first on the essential needs of food, shelter, clothing, and medical care. With what remains, we choose among other goods and services that we need or want, in a manner consistent with our personal priorities. If we foresee a future need or just have more money than we need or want to spend, then we save that money, thus allowing us to let spending exceed income at some point in the future.

What distinguishes people from an economic standpoint is not whether they make decisions, but rather how they make decisions. And a person could indeed potentially reduce every spending decision to the underlying economics. For example, here's a possible thought process for buying a cup of coffee:

"I make $10 an hour. My favorite coffee costs $5. I could get a cup of plain black coffee at work for nothing, but I really like my double mocha latte. On the other hand, I work for half an hour to earn the $5 for that coffee. I'm not sure I like it that much."

The value of time
With a little work, it's easy to translate costs from money to time. For various common items, here's an estimate of how long it takes to earn the money to buy them.

Because people earn money at different rates, even people with identical priorities might make different decisions based on their income. When you combine 300 million Americans with different incomes, preferences, and priorities, it becomes very clear why macroeconomic analysis is so difficult to perform successfully.

At the individual level, this table also gives you another way of thinking about purchases. Most advertising focuses on the fact that credit makes it as easy as possible for you to have what you want immediately. By distracting you from the true price of making a purchase, the seller hopes that you will place your desire for the product above the long-term cost. Only later does "buyer's remorse" set in as you realize that the long-term value of the product may not have been as high as you had thought.

Second-order effects of purchases
Valuing purchases in terms of time spent to earn the cost may be helpful, but it is too simplistic for many real-world situations. For one, it ignores the reality that certain purchases not only give you the immediate enjoyment of the product but also bring about some other positive result thereafter. Sometimes only by considering that subsequent positive result or second-order effect can you make an economically rational decision.

Consider, for instance, buying a suit. The difference between an off-the-rack suit from a discount store and a tailor-made suit may be so large that you would be inclined to take the less expensive suit if you only considered your own wishes. However, if buying the tailor-made suit gives you opportunities to improve your salary or get business from new clients, then it may be the right choice to spend the extra money.

Credit: tool and temptation
In a world without credit, no one could spend more than they happened to have at the moment. And although living without credit would make a certain level of financial discipline mandatory, it would also limit some spending and investment that would be beneficial to society as a whole.

Having available credit, of course, removes this limitation on spending. As a device to smooth, uneven flows of income, credit helps to stabilize a person's economic activity by allowing him or her to continue spending during temporary downturns in income.

When credit becomes a permanent replacement for income rather than a temporary smoothing tool, however, it does become dangerous. Because people tend not to look far enough into the future to see the consequences of using long-term credit, it is easy for advertising to use the lure of credit to encourage spending with minimal immediate cost. Only by considering all the ramifications of a credit transaction can one make an informed purchasing decision.

A world of economics
It is easy to dismiss economics as being unnecessarily complicated for use in everyday life. The fact is that people make economic decisions all the time, whether they realize it or not, and by better understanding the rationale for their decisions, people can avoid making costly mistakes and stay on the road to financial security.

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Dan Caplinger welcomes your comments. The Motley Fool is investors writing for investors.