Two main reasons for studying economics are often mentioned in textbooks and classes. First, it helps us understand the social world we live in and second, it makes for better policy decisions. An example comes from Adam Smith in The Wealth of nations. By understanding what makes one country rich compared to others, we may be able to develop a roadmap for other countries to achieve prosperity as well.
A less often discussed motivation for learning economics is to make better personal decisions. Economists use economic reasoning to make better decisions in their personal lives, but they don’t always portray this as a great benefit to their students or the public. This may be because economics is too often conflated with the study of finance or business; Economic theory is not a set of recipes for making money. However, it can help students get a clearer picture of how to get the best out of life.
There is some truth in jokes about how you don’t need a genius to get rich. Here’s one:
At a ten-year high school reunion, a high school math teacher arrives in a beat-up old sedan and an old friend of his pulls up in a shiny new convertible with all the trappings of wealth. The math teacher remembers that this friend barely dropped by during his high school classes. “You seem to be doing well,” he says as he greets his friend, “what’s your secret?” The friend replies, “I just follow the 5 percent rule.” Buy something for five dollars and sell it for ten dollars.
It is true, and probably a virtue of market economies, that individuals with little in-depth knowledge of mathematics or how the world works can accumulate wealth, but it is more likely that wealth can be maintained with some understanding of economics. It is possible to have a high income yet little actual wealth if that income is poorly managed or if the opportunity costs are poorly assessed.
A basic assessment of opportunity costs can inform financial decisions. For example, it is almost always better to finance something over a period if 0% interest is offered. Now, if you have to pay €1,200 or €100 per month for 12 months without interest, the latter is a better deal, as long as there are no significant transaction costs involved. If you make your payments on time each month, earning simple interest on the money in the bank, and assuming the interest rate is 5 percent, you will earn about $27 extra in interest that year. Therefore, you get what you bought and $27 (which would be higher with compounding). Many such decisions can add up, and every dollar counts.
One consequence of this is that it’s probably not worth it to pay taxes early. If you get a large refund after you file your tax return, you overpaid during the year and essentially loaned your money to the government at zero interest for the period between your payment and receiving the refund. Individuals may fear a large tax bill at the end of the year, which is understandable. You could put the money you owe the government in an interest-bearing account until the end of the year, then pay the taxes and then keep the interest earned. The same example above applies here.
The ‘efficient markets hypothesis’, developed by economist Eugene Fama, implies concrete advice on investing in financial markets: diversify and minimize transaction costs, you don’t know more than the market (and neither do professional portfolio managers). Economics doesn’t propose a get-rich-quick scheme, but it does propose a ‘get-rich-slow’ scheme.
To be fair, many economists provide explicit economic lessons for better decision-making. Justin Wolfers and Betsey Stevenson pay attention to it in their podcast Think like an economistwhich is still worth listening to even though they stopped producing episodes a few years ago. Steven Landsburg provides useful insights into The armchair economist. Tyler Cowen gives advice for using economics in An economist gets lunch And Discover your inner economist.
Bryan Caplan, in his blogging and new book, Self-help is like a vaccinehas used theory and clear thinking to provide actionable advice on real issues that people care about. Many have affirmed the value of his advice, and much of this essay was learned from him through his writing and teaching.
Jane Austen reportedly said that “a large income is the best recipe for happiness I ever heard of.” While funny and true, the law of diminishing returns suggests that an extra dollar above a certain income level won’t bring you much more happiness.
Economists know that money isn’t everything. It’s a stand-in for control over resources and the power to live the kind of life you want. If you can secure that life through non-monetary means, then it makes sense to do so. Of course, many people without formal knowledge of economics are already good at using such thinking to make life decisions, but they may not be aware that they are doing it.
Giorgio Castiglia is a program manager for the Project on Competition at the Mercatus Center and a PhD student in economics at George Mason University.