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An Economist’s Perspective on Personal Finance

September 20, 2013

Those of you that know me, know that I’m an economist at heart. No seriously, I LOVE econ and I would love nothing more than to teach econ to high school-ers (which I totally plan on doing as soon as we achieve financial independence).  Given this, and my last post on applying corporate finance principles to personal finance, I thought it would be equally enlightening for me to apply an economist’s perspective to personal finance.

For me, the Econ perspective and finance have always gone hand-in-hand – it is really how I intuitively think about personal finance, spending, “profit” and decisions about many things in life in general. 

Opportunity Costs and Quantifying Benefits

One of the main difference between how Economists and Accounts think about finances/profit has to do with the idea of costs.  In contrast to accountants, economists look at more than just expenditures; we also look at something called “opportunity cost.” Opportunity costs can best be conceptualized as a trade-off cost. It quantifies the cost of doing what you are doing now rather than doing something else. It also makes you value your time – something we often forget to do when we’re outside of work! For example, let’s take a look at the cost of cleaning your house. Assume it takes you 4 hours to clean your house and you use $5 of cleaning supplies to accomplish this task. Let’s also assume that your time is valued at $25/hour. An account would say that it cost you $5 to clean your house.  However, an economist would say that it cost you $105 to clean your house ($25/hr for your time * 4 hours of cleaning time + $5 of cleaning supplies). That’s a huge difference!

Similarly to accounting for costs, Econ also advises us to quantify the benefits of any given choice. Continuing with the example above, let’s say that you have the choice between cleaning the house yourself or hiring someone to do it for you. Assume that hiring someone costs you $75. Comparing just the economic costs would suggest that hiring someone is the most rational decision. However, we only have one side of the equation, we need the other – benefits.  Clearly the benefits I derive from hiring someone are $4 hours of free time with are valued at $100. So by hiring someone, I end up with +$25 ($100 benefit – $75 cost = $25). Now let’s look at the benefits of cleaning the house ourselves. First, we have the obvious $75 savings from not hiring the cleaning lady. Let’s also say that we get a sense of accomplishment/pride at doing it ourselves which we value at $30. Let’s also say we get a health benefit from scrubbing, walking up/down stairs, etc. that we value at $30. That gives us a net benefit of +$30 ($75+$30+$30 – $105). In this case, we ultimately get the most benefit by cleaning the house ourselves.

Maximizing Utility

Another key assumption in Econ is that individuals are rational and seek to maximize their utility.  Now, let’s not argue about how this may or may not hold true in the real world. Rather, let’s focus on this concept of utility.  What do we mean by utility? Utility is the amount of satisfaction or benefit an individual receives and is generally tied to consumption (i.e. spending). As consumption increases, utility also increases. However, this utility increases at a diminishing rate. What this means is that the first dollar of consumption corresponds to a huge increase in consumption, the second dollar corresponds to a smaller increase in consumption, and so on.  The graphs below gives a better visual representation of this:

Image

Image

As I think about these concepts more, it is really obvious that most people focus on the first graph that shows that increased consumption always results in a higher total level of satisfaction.   However, what people fail to account for is the second graph, or what we economists call, marginal utility.

Now let’s relate this to personal finance and spending habits a bit more. The first graph tells you that the more you consume, the more satisfaction you have. The second graph tells you that once you reach a certain point, extra consumption doesn’t really increase your incremental satisfaction that much.

Let’s use a car as an example to relate all these points and graphs together.  Let’s say that each car you buy costs you $15,000. Now let’s also say that the first car you buy gives you $40,000 in satisfaction, the second car gives you $30,000 in additional satisfaction, the third car gives you $15,000 in additional satisfaction. Your total satisfaction would be $40,00+$30,000+$15,000. = $85,000. This corresponds to the firs graph and the idea that your total satisfaction increases with additional consumption.  This is what most people tend to focus on. However, let’s look at what each dollar actually buys you in terms of satisfaction:

  • When you buy the first car, each dollar you spend generates $2.67 of satisfaction – not bad!
  • When you buy the second car, each dollar you spend generates, $2,00 of satisfaction
  • When you buy the third car, each dollar you spend generates $1.00 of satisfaction.

Thinking about consumption this way, can be extremely eye opening and can be especially helpful when you’re trying to get out of a pattern of overspending and debt. Here are a couple ways me and my hubby have applied it in our lives:

  1. Coffee – How does my marginal satisfaction change when I buy/drink a grande coffee from Starbucks compared to drinking coffee made at home? Is there really a difference in the satisfaction I derive from these two alternatives? I’m pretty sure that my marginal utility for drinking coffee is the same, regardless of whether that coffee comes from Starbucks or from home
  2. Eating Out – I actually feel physically healthier when I don’t eat out for lunch every day, but I had gotten into the habit of it over the summer when my client site project moved locations into DC. It was so convenient but I probably gained a few pounds because of this new habit and it was expensive! Even assuming I got the same satisfaction from of eating out as from packing a lunch, my marginal utility is much higher for packing a lunch.

Commodities v. Differentiated Goods

We are constantly inundated with ads, commercials, billboards, etc. telling us how we have to buy all these random things and how buying them is going to make our lives so much better. But really, is that $400 purse going to make me 4x more satisfied than my $100 one? We are constantly bumping up against marketers’ efforts to differentiate products that we forget that most of the things we purchase are commodities, and not really all that different. I’ve spent time in several marketing classes and what a lot of it comes down to, in my opinion, is understanding your target customer segment enough to be able to tell them how your good or service meets their need or solves their problem BETTER than a competitor. Think about smart phones – Samsung’s message highlights superior functionality and open-source technology; Apple’s message focuses on integration of products and ease-of-use. However, at the end of the day, MOST people do not use either phone to their full capacity. Rather, they use the phone to make calls, send some text messages, listen to music, take pictures and check Facebook.  From this perspective, does it really matter whether your phone runs on iOS7 or on Adroid? How much of your satisfaction is really derived from the brand or the operating system?

The nice thing that comes with commoditization of goods is that there are suddenly a lot more alternatives out there, which means a whole lot of opportunities to save money.  Take the smartphone example – by identifying that most of your utility comes from functionality rather than brand, you open the door to a variety of other options that may save you hundreds of dollars!

Bottom Line

My ultimate take away, and the thing that I love most about Econ is how it forces us to think beyond dollars and cents, by making us think in terms of dollars and cents. You can’t just compare price tags, you have to  dig deeper and figure out how much you value intangibles (like  time) and to determine what really gives you satisfaction. It forces you to think about trade-offs and quantify these costs so that you better understand what you are spending your money on, and what you are giving up when you do.

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4 Comments
  1. Great article! I graduated with a degree in Economics, so my brain works very similarly!

    The one short coming about economics tie in with personal finance is the word personal.

    I firmly believe that about 95 percent of personal finance concepts can be explained with a little common sense and 6th grade math; yet a majority of people live paycheck to paycheck because they either lack attention to their finances, have a sense of entitlement or lack personal responsibility. For example – if someone believes they work hard and “deserve” to drive a new car, its very difficult for financial logic and reason to gain a foothold.

    Keep up the nice work! I enjoy reading your posts!

    • Alex – it’s great to get the thoughts of a fellow economist! I agree that there is much to be said for personal responsibility, but I also think there are a lot of cultural influences that put pressure on people to act or consume in a certain way. I like to think of it as the individual’s “Freedman v. Freeman” dilemma – do you focus only on yourself (i.e. increase short term shareholder value) and what brings you satisfaction here and now or do you focus on friends, family, etc. and the long-term impact/satisfaction of your decisions. I think a big problem is that there aren’t that many models for the latter, and people are bombarded with the message from childhood that instant gratification is a right – that, as you say, when you work hard, you deserve some reward right away. I also think that being able to successfully manage your personal finances has a lot to do with self-esteem, and a true understanding of one’s self. Just like there is usually an emotional issue underlying most people who struggle with weight, I think there is also an emotional issue underlying those that struggle with personal finance. When you start defining your satisfaction, your self-worth and your success by things, you are bound to end up in debt or living paycheck to paycheck, even if you’re making a ton of money.

      I guess this a long-winded way to say I totally agree with you, but I think that entitlement or lack of attention to finances is really just a symptom of a much deeper rooted problem. You may have just inspired my next post!

      • Great reply….if there was a “like” button for replies on wordpress, I would have pushed it 🙂 I look forward to reading your future articles!

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