Tuesday, July 29, 2008

Economics and Personal Finance

For some people personal finance can boiled down to the great Saturday Live skit “Don’t Buy Stuff”, shown below. But sometimes the questions are more subtle.

Where can economists shed light on personal finance decisions. So here are a few things I think intro to economics helps with personal finance.

1.If it sounds too good to be true it probably is. Imagine there was a business anyone can do where you could easily sell something and make lots of money. Then everyone would do it, but then prices would have to be lowered and profits would go to zero. So whatever great business idea you have, if someone else might have it won’t make as much money as you think.

2. Consumption Smoothing. Most of the time the more we have of something (money, beers, bananas, what have you) the next additional unit still makes us happier, but the increase is not as much as the last unit. This is called diminishing marginal utility. In terms of personal finance spending a $1,000 extra dollars when we make only $20,000 is better than spending $1,000 more when we make $100,000. Or as Milton Friedman told Steve Levitt “Don’t Save Too Much”

3. Risk Aversion. By the same token losing a $1,000 is a lot worse when you only make $20,000. So we should save to avoid the pain of severe loss of income. So Levitt and I ignore the advice, and probably “Save too much.”

4. People Respond to Incentives. If you give people money to do stuff, they are more likely to do it (most of the time). But how to get yourself to save more or think about personal finance is difficult. I like Tyler Cowen's take on when people will and won’t respond to incentives, in his book Discovering Your Inner Economist.

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1 comment:

Ethan said...

You forgot one more thing:
"When you are studying economics in college, you will have no money, so don't bother trying to buy anything."

At least, that's been my experience at Grinnell.