1. Everything has a cost.

This could also be called “there ain’t no such thing as a free lunch.” Opportunity cost or simply “cost” is fundamental to economics. The cost of something is the next best alternative. The $5 footlong does not cost $5. It costs “the next best thing,” whatever that is to the person.

More importantly and less recognized, economics taught me that time has a cost. Even if I am attending a “free” lecture, watching a “free” movie online, or enjoying someone else’s “free” food, I am paying a cost, whatever else I could have done.

Economics taught me to consider all available alternatives. Every decision is about the best choice given the proper understanding of cost, not just price. Viewing time, price, and countless other subjects under one idea, cost, helps improve decision-making. Dollars and cents can be an easy approximation, but life isn’t about easy. Do the proper calculation.

http://www.youtube.com/watch?v=l-gQLqv9f4o

Short story- a friend once asked me if I thought what we were talking about was the best use of our time. I quickly said yes. I had already thought it through and decided that talking with her was my best option among all available alternatives. She didn’t think it was a compliment, but I thought it was.

Insight #1 has also helped me be more positive. I know that I am making the best decision given my information. There is always room for growth and improvement down the line, but at any moment I am doing the best thing I can. I didn’t do great on an exam, fine, I decided that the extra studying was not worth my time. I calculated that at the time. There is room for future improvement (see #’s 4 and 5), but my past decisions were correct ex ante.

2. Information and knowledge are expensive.

Before studying economics, specifically, before reading Hayek and Sowell, I was fairly confident about my understanding of the world. Back in B.E. (Before Economics, it’s an actually dividing line for my life), I could tell you when people were making dumb decisions, what the problems were with policies, or why a certain event happened. Now, I am much less confident.

Information is highly dispersed. Even the smartest people in the world do not know a minuscule amount of the information that everyone else knows. This makes sense. It is costly for me to gather information and I often do not have the incentive. Shareholders who are paying CEOs millions or school districts who are changing curriculum have more info on their choices than I ever could. If I think they are doing something wrong, I should take a step back. I am still highly skeptical of others, but I am also skeptical of my understanding.

A corollary is that even if I (or anyone else) cannot explain something, it does not follow that there is not reason. Again, disperse knowledge is more than anyone can understand. I, Pencil is an example of this. Money is another.

3. People are rational.

I don’t mean that people are computer-like calculators of pleasure and pain. I do not mean that people have perfect foresight and perfect information. My definition of rationality is less demanding, but still helps me make sense of the world.

Why would someone go skydiving? I never would, mostly because I’m a little baby about heights. However, I can understand that people calculate and decide that skydiving is their highest ranked alternative and go. People can think things through.

Now, before readers accuse me being some overly crazy subjectivist (just a mildly crazy subjectivist), I don’t mean to explain everything by saying “she wanted to do X, so she did X.” Rationality means that people respond to incentives. If price of a TV goes down, more people will buy it, simple supply and demand stuff. In my daily life, this teaches me that if raise my personal price (by being more annoying or less friendly), people will want to hang out with me less. People aren’t dumb. They respond.

Of course, everyone knows this. People accuse economics of simply proving that water runs downhill. That is part of it, but economics is not just common sense. Economics forces me to ask, why would someone do that? And “they are crazy” is not a good enough answer.

4. Maximize lifetime happiness.

It is easy to get stuck in the present. What is the most fun today? What will make me the most money today? How can I pay my bills today?

While today is the most important day in any decision, it is not the only one. I need to take into account the future. Again, this is obvious, except when it’s not.

Some people argue to avoid debt. Of course, if the decision is debt vs. no debt, ditch the debt. However, that’s never the case. I need to look at decisions through time. Many decisions are actually investment in relationships, careers, hobbies, or goals. If they rewards will pay off over time, I need to not ignore that. The real choice is often between (1) debt plus whatever the debt pays for and (2) no debt.

Another anecdote- I bought an iPad in August. I love it. I’m probably on it too much. However, I calculated that it would “pay for itself” in a few months and it has. Since I am not working, I paid for it indirectly through a loan, i.e. more debt. If I would have been fearful of debt (which is a current balance-sheet number, not an expected lifetime number), I would have made the wrong choice.

My iPad has increased my productivity and the number of books I can read (thank you PDFs). From a pure dollar calculation, it has saved me money. Now, this increased reading will hopefully also pay off in a better job in the future. Again, many decisions are investments. Add it all the “non-productive” benefits, it was a clear choice. I try to make the same type of decision (with varying levels of focus) with all decisions, not just college, housing, or portfolio management.

I am not saying buying things makes people happy or that endlessly consuming is good. I’m saying people need to keep the “big picture” in mind and not be short-sighted.

5. Ignore sunk costs.

My fiancé hates when I use this in discussions. However, I keep mentioning it, because it is vital and easy to forget. People act in the present to change their future state to something better. Nothing in that statement, which is true, refers to the past.

Nothing changes the past. When I was debating whether to pursue a PhD in economics, it would be easy to say I’ve put in all this training at my masters to prepare me: don’t change paths now. That would be faulty reasoning. Instead, I asked, given the current situation with all the good and bad things that have brought me here and no matter the past, what should I do? This helps me avoid throwing away more time and money into a lost cause. Move on. You’ll be better for it. The goal is to maximize future benefits.

I’m sure I am missing some and some of these combine for extra help, but this is my list. Some more examples are in a 2007 graduation speech by Thomas Sargent. His are short and sweet. Some bloggers liked them. Some didn’t. Everyone should check them out and make up their own mind.

What have we both missed? How has economics helped you?