The most important financial asset that exists isn't gold, cash, or even stocks — it's knowledge. Give a man a strong understanding of finance, investing, and economics, and he'll be much more likely to succeed in the material world than if he didn't have that knowledge.
In this post, let's take a look at one of the most neglected branches of human knowledge — a topic that should be exhaustively covered in high schools, but unfortunately is — economics.
More to the point, let's analyze three principles of economics that everyone should understand, whether you're involved in central planning or just budget planning.
1. Trade Offs: There's No Such Thing As a Free Lunch.
This is probably the most important “lifestyle economics” principle: all good things require trade-offs. A more common way of describing this is through the old cliche “there's no such thing as a free lunch.”
In order to go to college, for example, one might nee to give up 4-5 years, possibly tens of thousands of dollars, accept debt, live in cramped spaces, and go without concistent sleep for literally years. It might be a wonderful decision — especially if it's an Ivy League college — but it still requires trade-offs.
Being honest about the tr`ade-offs and the real costs of everything we do, have, and spend money on. This is important, because it allows us to focus on our real priorities. For example, what's more important: earning extra money we don't need, or spending time with family? Earning extra money for retirement, or living a luxurious lifestyle that cuts away at savings?
Being honest about our priorities, and understanding that everything “costs” something, we're more likely to pick actions that lead to the most possible gain for ourselves and our families.
2. Supply and Demand: If You Build It… They Still Might Not Come.
This is probably the most important issue of economics. If there's a large enough demand, and it's theoretically plausible to fill that demand, then the supply will be filled. This all works on a curve of course.
For example, why do some people decide to work at McDonalds? It's not a great job, now is it? The answer is in supply and demand — several layers of it. There's not a greater supply of better jobs, but there is a large enough demand for money that people who don't like the place will end up working there.
An old economist once joked that you could train a parrot to squawk “supply and demand” and that it would be able to answer every economics question asked of it. That's pretty close.
Why do American keep voting for a congress that they don't really like? Supply and demand. Why do people not work out even though they keep planning on it? Supply and demand — they have other things to do, and other values, etc.
Of course, supply and demand really only makes sense when we understand how trade-offs work as mentioned above. Both of those principles mix together so that the world makes at least a little more sense in light of them.
“Supply and demand” is how the market reacts to individuals who are themselves responding to their own individual incentives. Nothing is exempt from supply and demand. Elections, markets, regulations — they either account for it, or they have serious unintended consequences.
3. Scarcity. Almost Everything is Limited.
We only have so much time on this earth. We only have so much intelligence. We only have so much oil. The same goes for gold, land, etc. Because scarcity exists, the question then becomes — how do we handle this scarcity?
Pretending the scarcity doesn't exist can have huge consequences. In America, we see this mostly as an issue of consumer debt. In America, our government sees this happen almost always through federal debt. The leading cause of debt is people who refuse to accept that their financial resources are scarcer than they'd like.
Once you understand scarcity, you're more likely to understand supply and demand. And once you understand supply and demand, you're more likely to know how to respond to choice by making the right trade-offs.
Of course, these concepts are economic concepts, meaning they apply to way more fields than personal finance and investing — they also cover politics, psychology, and even moral behavior. That's why the study of economics isn't just the study of money — it's the study of human behavior in general.
Paula @ AffordAnything.org says
Whenever I hear people complain about how much an athlete or rock star gets paid, I think to myself, “Scarcity — how many other people can do what he does?”
Sure, it doesn’t seem “fair” that some people who are in noble professions earn very little, but understanding these 3 economic principals that you outline above helps us understand WHY that’s the case.
That’s true, Paula. I just recently read over an article explaining why Derek Jeter, though he’s getting paid millions per year, is worth every penny just from the wins he generates through above average performance.