Think like an economist

In honor of the Nobel Prize in Economics being awarded this past week, here’s a primer on how economists see the world.

1. We’re all nuts.

People don’t always make rational judgments and our decision-making is flawed in a myriad of ways. A more interesting question is whether we are predictably irrational? That’s less clear.

2. Umbrellas don’t cause rainstorms.

We confuse correlation and causation. Just because two things are associated with each other does not mean that one causes the other. Or as Paul Krugman has suggested, soup kitchens didn’t cause the Great Depression.

3. Are you feeling lucky?

We are fooled by randomness and conflate skill and luck. I know from personal experience playing poker and bridge — when I win, I’m sure my success was due to my superior skill but when I lose, I’m equally certain it was my bad luck. I’m not the only card player to feel that way.

4. We like bargains.

Economists say that demand curves are downward sloping. In English, we say, duh — people buy less stuff when things cost more.

5. We dislike commitments.

Option value is when people have the flexibility to cancel on demand. Said another way, we need to be incented to commit to longer term contracts such as a health club membership, phone agreement, or bank CD.

6. Life is full of trade-offs.

We need to make choices between guns versus butter, consuming today versus saving for tomorrow, or opting for more or less risk in your investment portfolio.

7. Life isn’t fair.

Equity (that is, fairness) and efficiency conflict and the right balance is a political choice. Social welfare programs may incur waste and fraud, but when you tighten up controls, deserving recipients also suffer. Corporate welfare never seems to be held to the same level of scrutiny.

8. Tom Brady shouldn’t mow his own lawn.

The law of comparative advantage suggests that each of us should focus on what we do best and trade with others when it makes sense. But, free trade does not make everyone better off. (See point #7.)

9. There are no more cod in the Gulf of Maine.

The tragedy of the commons occurs when we over-consume a common good such as a fishery or grazing land. Economists have a solution known as the Coase Theorem that works in theory — there are still lobsters in the Gulf of Maine — but it’s difficult to implement as it is not fair to everyone. (See point #7.)

10. Don’t ask a barber if you need a haircut.

Principals (that’s you) and agents (that’s the other party with whom you transact) often have misaligned financial interests. Whether they are surgeons, auto mechanics, or financial advisors, what is best for them may not be for you. Trust if you must, but verify if you can.

11. There are no free lunches.

In spite of the Gamestop phenomenon, markets are efficient, meaning opportunities for high returns require taking large risks. As the old joke goes, “Why didn’t the economist pick up the $20 bill on the sidewalk? Because if it really was a $20 bill, it wouldn’t be there.”

Now you can win a Nobel prize.

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