I’ve decided to make these first few posts pretty linear in their subject content. What that means is that if you haven’t read the last few posts (particularly this one), you’re likely to get less out of the post. I’ve mentioned this before, but to get the most out of the site, I really recommend you read these other posts. As of now, the site is very early in development so there isn’t a whole lot to read through. But I can assure you that there are more posts coming that will reference a lot this perspective.
I wrote in other posts and in the little site description to the side of the site that economics is a perspective. It’s a way of looking at things. It’s a lens. Attaining that lens takes time and effort. I’ve tutored and taught dozens of students whom in particular expected economics to pretty simple, that it was nothing more than a matter of memorizing definitions. That method of memorization simply doesn’t teach the lens. It teaches the terms, and you will likely be able to use the terms in a technical conversation. But to really grasp economics, the understanding of the lens, of how a problem or situation is perceived, is paramount. In simple terms, it’s important to know the story we are trying to tell. No matter what we talk about, there is a story that is trying to be explained or theorized. Understanding that story allows us a more intuitive understanding of what we are trying to accomplish. Yes, we will throw technical jargon at it and turn it into an objective science, but underlying it all is that story. Not understanding that story makes it very difficult to understand anything else.
Fortunately, understanding the story is probably the easiest part of the entire process. It just takes a little time to grasp this lens and get used to recognizing the story. To demonstrate, this post is going to look more closely at some of the decisions that we make every day. The goal isn’t to necessarily bombard with technical knowledge but to drive home the idea that the story, the intuition, is important. So, we all eat, right? How we make that decision is what is going on after the break.
I made the point in the previous post (click if you haven’t taken a look yet) that there are thousands of situations every day that involve economic decision making. The grocery store is a classic example of such decision making. To further gaze upon these familiar settings, let’s take a look a little more closely at the economics of what to have for dinner.
Is a Morton's steak dinner in my future?
The central story is quite easy to grasp here. Imagine you are deciding what to have for dinner (assume for now that it is just you… table for one). Clearly there are multiple answers here. You could eat in and cook yourself something you have at home. You could go pick up something at a fast food joint or a take out restaurant. You could also go to a sit-down restaurant. Within those options there are different foods available. Do you cook yourself the chicken or the steak? Do you pick up a Subway sandwich or from some local Greek place? Does cheesecake at Cheesecake Factory sound good? Lots of options here and the ultimate decision that is made is an economic decision. We understand the intuitive story and the question is how the economics works in this story.
Previously, I’ve written about rationality. It’s a pretty nice concept that allows us to objectively determine what decisions are going to be made. If someone gets more satisfaction from option A than I do from option B, all other things being equal, that someone will choose option A. It makes no rational sense to choose option B which brings you less utility. Previously, even in that last example, I’ve used a little phrase that’s helped simplify a lot of things: “all other things being equal.” It’s helped me to avoid a couple of catches when it comes to rational decision making.
Specifically what I am referring to here is cost. You might have thought that the dinner decision was made simply by picking the thing that you wanted the most. More precisely, you would eat whatever it was that brought you the most satisfaction. Surely you would want to get a lot of utility from your meal, but about the cost of that meal? Sure, I would love to have a Morton’s steak every night. That steak brings me a lot of satisfaction, but it also brings me a lot of cost. Imagine if I had a Morton’s steak that gave me 100 utils of satisfaction. But also imagine that this steak cost me 50 dollars. Should I decide to buy and eat the steak?
This question brings up one of the key ideas that constantly circulates around in this economic world: all things are relative. Whether the steak is a good decision or not is all a matter of relatively. What else could I get with my money? What am I giving up in order to attain the steak? (Note: what I am really talking about here is opportunity cost. The price of the steak is 50 dollars, but the opportunity cost is the potential hamburger I could get or the pasta I could make for myself.) If it turns out that the steak brings me the most satisfaction per dollar compared to any my alternatives, then I make that decision to get the steak. This is the optimality condition for the dinner decision. I want to maximize my utility per dollar spent. It makes no sense to get the steak if it costs me a million dollars to get it. I could easily get just as much satisfaction as the one steak for much less with some other dinner.
Thus, the dinner decision you make is ultimately trying to weigh how much satisfaction you can get per dollar. I end up filling myself up with a Dairy Queen vanilla ice cream cone at night because it brings me a lot of satisfaction for not that much coin. I don’t choose to go get a smoothie since it brings me at most as much satisfaction for more money.
At night, I get in arguments with family and/or friends about where to go to dinner for this very reason. My goal in the group scenario is to maximize the utility per dollar spent for the entire group. This is something that family likes to call “passive aggressive” but what it really is is something a little more complicated than me being annoying. To simplify this scenario, imagine a big pot and in the pot goes all these satisfaction “pieces of gold.” What I want to do is get as many “pieces of gold” in the pot for as little money as possible.
Using this Lucky Charms sort of approach, if I am not particularly hungry and not desperate for a nice meal, my additional utility will be lower than the rest of the family. The marginal utility of my meal is low. Thus, the amount of gold I can put in the pot is very low. If we decide to go to a meal that I like most but that gives less satisfaction to everyone else in the family, I am keeping gold from going in the pot. I want the most gold in the pot and therefore need to let those who will bring more satisfaction (i.e., who are most hungry) make the decision.
Ultimately, with this economic mindset, the decision that is made is quite easy to determine. If I have two options, A which brings 100 utils of total utility for 50 dollars and B which also brings 100 utils of total utility for 25 dollars, the optimal decision for the group is to go with option B. I am getting a lot of gold in my pot for less money. Whether or not you consciously think about getting the most gold in your pot (I’m betting you’re a little more sane than me and don’t imagine your own gold pot), this decision is still made with this framework. You naturally make this decision. Otherwise, you would be constantly paying for things that are bringing you less satisfaction. Eventually, you will determine what you like and will work to get the most of it for the least amount of money. Again, you may not consciously go through all this util-talk but it is human nature to want the most benefit for the least cost.
The last idea I will mention in this post spurs from this last mini-scenario. What if you do make a bad decision? This whole post might suggest that you are always going to make the best decision without fault. This idea is what leads a little modification that can be made to this rationality concept. This modification is called bounded rationality. In simple terms, it means that yo make the best decision you can based upon only what you know. As an example, imagine you go get a Morton’s steak and have a nice meal. At the time of the decision, it was the best decision you could make. But afterwards, let’s say that you remember about this other restaurant you went a year ago but forgot about? It would have brought more satisfaction per dollar than Morton’s. Ultimately, the decision to go to Morton’s wasn’t optimal in the grand scheme of things. But based upon your bounded rationality, based upon what you knew at the time, it was the best decision to make.
This idea of bounded rationality explains how you could make a poor investing decision, for instance. Naturally, you wouldn’t invest in something if you thought it was a poor opportunity. But you might invest in something based upon limited research you have done (that is, you haven’t read every sentence of financial statements or interviewed every employee) yet find later on that the opportunity wasn’t what you thought and end up in a bad investment scenario. Coincidentally, this investment example explains the idea that all stock prices are fairly valued at the time of the transaction. Looking back at the movie “Wallstreet”, Gordon Gekko says something pretty insightful that you might have overlooked. In essence, he says that wealth is essentially transferred and it’s simply a matter who is receiving and who isn’t. I won’t go hugely in depth into that statement right now (it takes more tools still needed to be built) but will use it to explain how a stock trade at the time of the sale sees no winners and no losers. It’s simply a transfer. On each end of the transaction is someone who is buying and someone who is selling. Each buyer and each seller believes, based upon their own bounded knowledge, that the stock price will either go up or go down and respond accordingly. If the buyer thinks the price of a stock is worth 10 dollars per share, he won’t buy it for 11. Likewise, if a seller of a stock believes his/her investment is worth 10 dollars per share, he or she won’t sell it for 9. You can see then that the only time stock is traded is when both sides of the transaction agree on the fair value of the stock. As a result, all stock prices are fairly valued, otherwise there would never be a transaction since one or both sides of the agreement would back out.
OK, I need a breather, you probably need a breather too. As I said at the end of previous posts, if this doesn’t make sense, I really recommend that you go through it again, especially before moving on to related posts. Also, leave questions, comments, send emails, etc. It’s way early in this project and I am eager to read some feedback on what you think or question about the site.
