Application of

At the start of the academic year, I always feel a little pressure to justify the study of
economics. Students come up asking things like, should they do economics or history?
Its hard to know what to say, but to get people excited about economics, its good to try
and think how economics can be applied in everyday life. Some of this is just common
sense, but economics can put a theory behind our everyday actions.

Buying goods which give the highest satisfaction for the price

This is common sense, but in economics, we give it the term of marginal utility theory.
The idea is that a rational person will be evaluating how much utility (satisfaction) goods
and services give him compared to the price. To maximise your overall welfare, you will
consume a quantity of goods where total utility is maximised given your budget. For
example, is it worth paying extra charges by airlines, such as paying for more leg-room?
Or pay to get priority boarding? Economics suggests we need to evaluate the marginal
benefit of these services compared to the marginal cost. See: Extra charges by airlines

Sunk cost fallacy

A sunk cost is an irretrievable cost, something we cannot get back. For example,
suppose we sign up for a gym membership at $40 a month for a whole year. We are
committed to paying $480, whether we go or not. If we are feeling unwell, should we go
to the gym to get our moneys worth or should we write off the sunk cost and maximise
our marginal utility for that particular day? See: sunk cost fallacy

Opportunity Cost
Photo: Takver

The first lesson of economics is the issue of scarcity and limited resources. If we use
our limited budget for buying one type of good (food), there is an opportunity cost we
cannot spend that money on other goods such as entertainment. Opportunity cost is an
intrinsic aspect of most economic choices. We may like the idea of lower income tax,
but there will be an opportunity cost in this case, less government revenue to spend
on health care and education.

Theres no such thing as free parking

Another example of opportunity cost no one likes to pay for parking, but would we be
better off if parking was free? Most likely not. If parking was free, demand might be
greater than supply causing people to waste time driving around looking for a parking
spot. Free parking would also encourage people to drive into city centres rather than
use less environmentally friendly forms of transport. It would increase congestion;
therefore although we would pay less for parking, we would face extra less obvious
costs.

Behavioural economics and bias

Traditional economic theory assumes man is rational. However, the work of behavioural
economics suggests we can be prone to bias and irrational behaviour. For example, we
may be prone to a present bias where we overvalue pleasure in the short-term and
ignore long-term implications. For example, consuming demerit goods like alcohol or not
saving sufficiently for retirement. The insight of present bias suggests we make
decisions our future self would not make. If we become aware of these bias and
irrational behaviour, then we can make better decisions which improve our long-term
welfare.

See: Behavioural economics

Irrational exuberance

Another issue in behavioural economics is that of irrational exuberance or when we get

carried away by an asset bubble. Can we be sure we will not get carried away by a
boom and bubble? History suggests that many investors are over-optimistic about their
ability to leave the market at the optimal time and can feel that this time is different.

See: Irrational exuberance

On the other hand

In economics, theres always another way of looking at the world. Borrowing is bad,
except when it isnt. Nothing is black and white in economics; it depends. For example,
government borrowing to finance pensions for an ageing population can lead to an
unsustainable rise in government debt. However, government borrowing during a
recession can help the economy recover.

Diminishing returns

If we like chocolate cake, why do we not eat three per day? The reason is diminishing
returns. The first chocolate cake may give us 10/10. The second cake 3/10. The third
cake may make us sick and give a negative utility. People may have different opinions
about when diminishing returns set in. Some students may feel this is after the second
pint, other students only after considerably more. There are also diminishing returns to
money. That is why we dont spend all our time working extra money gives
increasingly less satisfaction and reduces leisure time

DIminishing returns to wealth/income

A similar concept is that of diminishing returns to wealth and income. Does an extra
$100 give us more utility? Yes, but it depends on our current income. If we have a very
low salary, the extra $100 will make a big difference. But, if we earn $100,000 a year,
we may not notice that extra $100 a year. The importance of this is for choosing the
right balance between work and leisure. What is the value in working a long working
week, if the extra money earnt has a limited marginal utility?

Externalities

Economics may feel we are promoting selfish ends firms maximise profits, consumers
maximise their personal utility. Adam Smith claimed pursuing selfish goals ended up in
improving the greater good. But, in economics, we also try to consider the impact of our
actions on other people. If a firm produces chemicals, it may make a profit, but cause an
external cost of pollution. To ignore this external cost would be to create an inefficient
outcome. We should make the firm pay the cost of its pollution so that it has the
incentive to minimise or halt external costs. Externalities are everywhere. Even your
decision to study economics could have positive externalities in the future. For example,
you could end up being an economics teacher helping others learn all about economics.

Public goods not provided by the free market.

The free market has many advantages. Private firms tend to be more efficient,
innovative and respond to consumer preferences. However, many goods and services
would either be not provided or under-provided in a free market. Public goods like street
lighting and law and order. Also, public services like health care and education would be
provided in insufficient quantities. Therefore, to optimise social welfare there is a need
for government intervention through taxes and direct public provision. We may dislike
taxes, but we would dislike not being able to see a doctor.
 Should I worry about automation and new technology?

There are concerns that new technology and automation will lead to job losses and
some people losing out. If our job is threatened by new technology is the fear justified?
Economic analysis suggests there it is a fallacy that new technology leads to permanent
job losses. This is known as the Luddite Fallacy though some jobs are lost, new ones
are created. Automation and new technology are not guaranteed to make everyone
better off especially in the short term. See: Pros and cons of automation

Macro economics affects everyone

Everyone is affected in some way by macro economic issues such as inflation and
unemployment. Inflation can reduce the value of your savings. If you keep cash under
your bed during high inflation, youd be better off trying to buy gold or some physical
assets. Mass unemployment can cause society to fragment, therefore there is a need to
adopt policies to try and reduce unemployment.

Life-cycle hypothesis

The Life Cycle Hypothesis states that to maximise lifetime utility, we should try to
smooth our consumption patterns over the course of our life. It is not good to have
substantial income when we are old and unable to move. Spending some money in our
student years will give greater overall utility. This justifies taking out a student loan to
pay back when we are working and then saving for a pension in our retirement.

Examples of economics in everyday life

Is the price of Starbucks a rip-off?
Is it rational to put money in an honesty box?
How will you be affected by a devaluation of the Pound?
How will you be affected by low-interest rates?
How will you be affected by a recession?