Eight Ideas That Will Teach You to Think Like an Economist
Economics is the study of human action—the choices people make in a world of scarcity. Scarcity means that people have unlimited wants, but we live in a world of limited resources. Because of this fact, people have to make choices, and choices imply trade-offs. The choices people make are influenced by the incentives they face, and those incentives are shaped by the institutions—rules of the game—under which people live and interact with others.
In this essay, I will explain eight ideas and give examples of economic thinking.
1 – Know the difference between price and cost
We often hear how wonderful certain countries are because they offer “free health care” or “free education”. Many will also say “I got it for free” because they didn’t pay with cash.
The mistake is in not understanding the difference between price and cost. For example, people often say, “The Starbucks latte cost me five dollars” or “The movie ticket cost me fifteen dollars.” Cost in savings means what you give up or sacrifice. In these examples, the prices were $5 and $15. But the cost of the latte was perhaps the sandwich someone could have bought for the same $5, and the cost of the movie was perhaps the three lattes that someone could have bought it for the same $15.
Labeling health and education as “free” is not only wrong—“there is no such thing as a free lunch”—it is also misleading. As my former teacher Walter E. Williams would say, “Unless you believe in Santa Claus or the Tooth Fairy, the money has to come from somewhere.” You may not get a medical bill in these countries, but it deducts more from your salary (i.e. taxes) and you may have to wait much longer to get that test or that “minor” surgery (from the bureaucrats’ perspective). You pay with money or time, but either way, you pay! Taxes are also used to pay for public schools, which is yet another example of how people call something “free” when it’s not.
There is a difference between zero price and zero cost. There may be a zero price ($0), but there is never a zero cost.
2 – Actions are more important than statements
“Actions speak louder than words” is a well-known idiom. Humans act, and the act of choice tells us something. Consider this example: A person walks into an Apple store and sees the price of the latest iPhone and angrily mutters, “What a steal,” but still buys the phone.
When someone does something voluntarily, they demonstrate their true preference in the moment. Assuming that individuals act in self-interest and will subjectively weigh the cost and benefit of an action, and also assuming that it is not a right to have private ownership of something (such as the aforementioned Apple iPhone), then when a person walks into an Apple store and buys the new iPhone, the individual obviously expects to feel better somehow at that moment. To say that Apple “took advantage” of the willing customer would be foolish, as Apple, or any private company, cannot force people to buy its product. It’s one thing to say something, but the proof is in the act of choice.
Sunk Cost Fallacy: Don’t cry over spilled milk
“Don’t cry over spilled milk” means what’s done is done. The only costs that should enter into our decision making are future opportunity costs. Past costs are “sunken”. The typical example to explain the sunk costs fallacy is the movie example. You spend $15 to see a movie and an hour into that three-hour movie you realize it’s awful and it’s only going to get worse. However, your feeling is that you should stay and get your money’s worth. This is bad economic thinking. The $15 is gone, so don’t waste the next two hours of your valuable time — get up and go.
Most of us know people who were (are) in a horrible relationship or dating the wrong kind of person (maybe this applies to you). But the feeling of “I’ve spent two years of my life with this person” can lead to a bad decision. Many end up marrying the person to justify the investment of time.
If you like yourself, don’t waste the next two years of precious time. It’s better to be single than in a bad relationship (but that’s for another essay).
4 – Learn to think on the margin
The optimal or efficient level of pollution is not zero. The ideal number of road traffic deaths or sports injuries is also likely not zero. The ideal number of people being infected by a virus is not zero. The ideal level of security is not perfect security.
The ideal level of security is less than perfect security. Nothing is free, including more security – tradeoffs are always involved because there is always an opportunity cost when we do something, even things like travelling, playing sports or interacting with other people.
Incremental decision making is what economists call thinking at the margin. Marginal means an additional or extra unit. Each time we make a decision, it is as if we are calculating the marginal benefit (the benefit of one more unit) and the marginal cost (what would be given up to acquire one more unit) of the action. The economic way of thinking says that something must be done until the marginal benefit (BM) equals the marginal cost (MC). There is also a concept known as the law of diminishing marginal utility – each additional unit gives less and less utility or benefit.
We want clean air so our eyes don’t get irritated when we go out and our lungs don’t burn when we breathe. However, if perfectly clean air is what you want, that would mean no more cars, planes, boats, or ships and trains (some would really want this situation, at least theoretically). This would incur huge costs for society.
Let’s look at it another way. If I snap my fingers and leave the Pacific Ocean perfectly clean, but then put a drop of oil somewhere in the ocean unbeknownst to everyone, would it be worth spending money, time, and other resources to hunt down that drop of oil? The marginal benefit of finding and removing one drop of oil in quintillion gallons of water would be less than the marginal cost. In plain English, it’s not worth it. Again, the optimal level of pollution is some, not zero.
When it comes to studying, playing a sport or musical instrument, or dating someone before getting married, you might think, “The longer the better.” I’m a literal person, so if I told my students, “The more you study, the better,” it would mean that they would never eat, drink, sleep, or spend time with family and friends. But common sense says that after studying for a certain period of time, most students will say, “I see” or simply “Time to move on”. Why waste more time studying?
Also, if you’re at a place in your life where you’re considering getting married, the point of dating is to get information about the other person so you can make a good decision. Eventually, you reach a point where you have enough information to propose, accept a proposal, or break up with that person. When I proposed to my wife, I didn’t have perfect information about her, but my information was good enough. Sure, another month of dating would have given me some marginal benefit in terms of additional information about her, but I got to a point where I had enough information — where BM = CM.
“Good enough is good enough” is what economists mean by doing something until the marginal benefit equals the marginal cost. The BM=CM rule implies that “more is better” thinking is not ideal. A bottle of aspirin may help your headache, but it’s dangerous to think, “Well, if one is good, the whole bottle is better.” Yes, your headache will go away, but so will you.
5 – Comparative Advantage: The ability to do something does not mean that one should
In a standard economics class, students learn absolute advantage and comparative advantage. The former means being able to produce more than another with the same amount of resources or using fewer resources to produce an output. The latter means being able to do something at a lower opportunity cost than the other.
As there is always an opportunity cost to doing something, it is sometimes advantageous to pay someone else to do something, even if we have the knowledge and skills to do it ourselves. This also has applications for trade policy. Just because the United States (actually, individuals in the United States) can produce certain products doesn’t mean we should. It’s okay if not everything we buy says “Made in the USA,” because if the government tries to “protect American jobs” and starts imposing tariffs and quotas, we’re not saving American jobs. It is more accurate to say that we are saving certain jobs at the expense of other American jobs. Of course, good politics and good economics often go in different directions.
6 – Supply and demand: understand how prices work
The claim that companies can charge “whatever they want” is nonsense. For example, why do movie theaters only charge $8 for popcorn and not $8,000 or $8,000,000 when they are supposed to charge whatever they want? There are two sides to a market transaction, and it is this interaction of sellers and buyers that determines the price. The interesting thing is that often the same people complaining are the ones who make noise eating that popcorn during the movie.
7 – Voluntary exchange is win-win that creates a bigger pie
Entrepreneurs get rich if they create a product or service that adds value to a large number of people. Unless entrepreneurs were given special privileges by the government, they did not take money from their clients by force.
Anger directed at the “rich” is based on the fallacy of thinking that the economy is a fixed-size pie. In other words, those who criticize the “filthy rich” believe they’ve taken too big a piece, leaving less pie for the rest of us ordinary people. The reality is that these entrepreneurs baked a bigger pie. They benefited, but so did we!
In a commercial transaction, exchanges are voluntary and voluntary trade is a win-win situation. The entrepreneur wins (as do the employees he hires) and the customers win.
8 – Fallacy of Good Intentions: Don’t Forget the Invisible Costs
Intentions and results are not always the same thing. The economic way of thinking teaches us to consider possible unintended consequences of our own actions or the actions of politicians. Just because something sounds good or feels right doesn’t mean a certain goal will be achieved. In fact, the very problem being treated can get worse.
Sound economic thinking also removes the blinders. The effects of a policy on all groups are considered, not just on one group. This helps individuals see through politicians’ claims that a policy will save American jobs when in reality only some special interest group will benefit at the expense of other Americans. When politicians confiscate money (i.e. taxes) to build sports stadiums using the argument “this will create jobs”, the mistake is to focus on the jobs seen and neglect the invisible – the opportunity cost of those tax dollars.
There is much more to say on this subject called economics, and there are many more examples of economic thinking that I could have included. Some characterize economics as applied common sense; yet economics also gives us counterintuitive insights.
This is the power and beauty of economics