Real Life Lessons that Economics Can Teach Us All

I often find people dismissing Economics as being "impractical", 'unscientific" or "idealistic", and when I try to debate otherwise, I get some heated arguments, most of them being along the lines of its inability to 'truly reflect the reality'. Considering that economic theories are formulated with a peculiar assumption of Ceteris Paribus, a Latin phrase that translates to 'holding all other factors constant', I do not blame the skeptics. Regardless, I believe that Economics is still a science, which emerged from the notion of scarcity, and I think it teaches some important lessons on life. Let me mention some of them. 

1. Expectations: Expectations about the future causes businesses and households (participants of the economy) to adjust their consumption, saving, investment and expenditure patterns accordingly, and these subsequently influence economic variables.

Let’s look at an example, within the Indian context to see how this works. In an inflationary environment, expectations of future inflation could become a self-fulfilling prophecy. For instance, if workers expect future inflation, they are more likely to demand higher wages to compensate for the increased costs of living. If their management gives in to their demands, the higher wages would increase the cost of the product / service that the firm sells. Moreover, the firm, in anticipation of higher inflation will increase the costs further to maintain adequate profit margins. Essentially, the higher costs will be passed on to the consumers causing what is known as Cost-Push Inflation. On the other hand, the workers who now have more disposable income will demand for more (or higher quality) goods and services. If the supply remains at the same, the prices will go up thereby causing inflation of a different kind – Demand-Pull Inflation.

Key Lesson: Expectations influence Actions, and hence Outcomes. If you believe you will succeed / fail at any endeavor, chances are, you're making another self-fulfilling prophecy. Thus, as the spiritual gurus say, stay positive !

2. Externalities: Externalities are spillover consequences (often non-monetary) of a transaction, experienced by unrelated 3^rd parties. These could be positive (read: social benefits) or negative (read: social costs), and could potentially lead to market failure if the social costs are not compensated for. On the other hand, social benefits tend to add to the business' goodwill. 

For example, schools, universities and research institutes emit positive externalities as education generates social benefits in addition to the profits for the institute selling the service (of education). Therefore, it’s a common feature in advanced economies for governments to either subsidize education or give incentives to education providers for the social benefit they bring about. On the other hand, large investment banks have been heavily criticized for taking on unsustainable amounts of debt leading to the Global Financial Crisis of 2007-08, and also amplifying the systemic risk in the overall banking system. These actions of investment banks (due to poor regulation) had brought about severe negative externalities that have now triggered in widespread social unrest (read: Occupy Wall Street).

Key Lesson: Your actions always have unintended consequences. Well-intended actions can sometimes have unintended ill side-effects too, and vice-versa. You can never be cautious enough. 

3. Dead-weight Loss: Dead-weight loss (DWL) refers to the monetary/welfare costs to society that are caused by market inefficiency, mostly arising due to poor policies or misallocation of resources. When a market is in equilibrium (i.e. demand = supply), there is no DWL. However, when price controls (minimum wage, subsidy, etc) are introduced, the demand & supply dynamics change and the new equilibrium point create a dead-weight loss. 

For example, imposing taxes on any particular product / service would not only reduce the seller's profits, but also cause some customers to shy away from making that purchase due to a higher price, thereby further reducing the profitability of the seller. In another scenario, imposing price controls (such as minimum wage & price ceilings) tends to restrict the businesses from functioning optimally, and creating DWL in the process. This loss of efficiency is then passed on to the consumer in the form of higher prices. In both cases, there is deadweight loss arising in terms of the monetary loss of profit for the seller, and in terms of the loss of utility derived from that particular product to the customer. 

Key Lesson: Let nature take its course, and only intervene when those forces are on a collision course, and external action is a must. Natural forces have a way of finding their own equilibrium.

4. Opportunity Cost: Opportunity cost is the cost of the action that has to be forgone, when opting for an alternative action, thereby highlighting the relationship between 'scarcity' and 'choices'. It is important to understand that the underlying assumption is that resources (time/money/labor) are limited and therefore there is always a trade-off on how to deploy those resources at any given point in time. One must note that the opportunity cost of an action may not necessarily be monetary in nature.

For example, instead of reading this post, you could have been baking a cake, washing your car, shopping, working, etc. Here, your opportunity cost is in terms of time (scarce resource), which could have been used for many possible activities (choice), and in the trade-off, you chose to read this post (excellent choice). In another instance, an investor decides that investments to make based on his capital and the available opportunities (both being scarce resources), and his decision (trade-off) is based on the pay-offs of each investment opportunity (returns, risk levels, etc). At the end of the day, one can use a $ 1 million to deploy at the stock markets, a new house, at a new business venture, or be used up for buying flashy goods, or be given to charity, etc.

Key Lesson: Our lives are determined by the choices we make, and while our options may seem limited, we must compare their Opportunity Costs to make the right decisions. 

5. Diminishing Marginal Utility: The Law of Diminishing Marginal Utility, in simple words, says that as an individual consumes more and more units of a product/service, the utility (read: satisfaction) derived from each consecutive unit, after a certain number of units, tends to decline. This concept applies to a production setting to, and a manufacturer may find his marginal utility diminishing by producing more units.

For example, Toyota currently manufactures 1000 cares a day. But to manufacture more cars per day, it will need to hire more workers, which will require more space to work, and also more wages to pay out. This may no longer be efficient because it may raise the average cost of producing one car. Hence producing more than the 1001^st car (and every car after that) will have diminishing marginal utility.  Similarly, consider a situation where you are very thirsty, and you drink water. Your 1^st glass will be very satisfying, but your second glass, though much needed, will not offer the same satisfaction as the 1^st one, and hence, will have lower marginal utility.

Key Lesson: More isn’t always better. Excessive quantity more often than not tends to defeat the purpose and backfire. This also applies to things such as hard work and happiness, where excess can lead to health problems and therefore, a natural decline in efficiency.

6. Fiat Money: It is currency that has been declared by the government to serve as legal tender, but is not backed by any physical commodity such as gold, copper, grains, etc. Therefore, its value is not intrinsic, but based solely on the premise that the counterparty would accept it as means of payment for goods, services and debt (or taxes in case of the Government).

As most of you know (I hope) transactions historically were made using the Barter System. This evolved to using commodities (grains, precious metals) as currency, until the 11^th century China, where the Yuan and Ming dynasties became pioneers of fiat currency. That being said, after the Nikon Oil Shock in 1971, almost all currencies in the world have been flat currencies. The problem with this is that since currencies are legal tenders backed solely by trust, it can become worthless due to hyperinflation if there is a loss of public confidence on owing to incessant printing of paper currency (the most recent victim of this was Zimbabwe).

Key Lesson: Always Have Faith. The moment you lose confidence, even the most prized assets – whether it is a skill, a person, or an object – become worthless.