When the word ‘Economics’ is thought about, what generally comes in mind is GDP, production, unemployment, central bank and government’s measures to sustain or support the economy. A common misconception is that economics is applied only at the macro level, that is to say, the economy of nations, the world economy and by corporate firms in the business world. These are the only areas to implement the knowledge of economics. But that is not true. It is much a part of our daily lives. Alfred Marshall, in his book Principles of Economics (1890), wrote: “Economics is a study of mankind in the ordinary business of life”. In fact, it is defined in basic terms as “the study of how society allocates its scarce resources efficiently”. Economics deals with the phenomenon of decision-making. Some of the situations involve money but most of them do not. The study of economics bloomed by the urge to understand and improve the decision-making at the individual household level. Macro-economic analysis came into the picture much later after the Great Depression during the 1930s. Issues like these of inflation, unemployment, recession etc. were investigated around this point of time.
Economics has applications in the most intrinsic instances of our lives. The following article discusses some examples of economic theories and concepts finding functionality in our day-to-day lives.
TRADE-OFFS AND OPPORTUNITY COST
The most basic concept of economics is the idea of trade-offs. Resources are limited. The money we have in our wallets is limited. We all have got 24 hours in a day. Even the time we have to ourselves is also limited. Evidently, it is not possible to have or do everything we want. Therefore, we face trade-offs. To acquire something we like, we have to give up something else that we also like.
Governments face trade-offs between using tax revenue to repay the national debt v/s spending it on improving the infrastructure of healthcare and education. Another famous example is a trade-off between “guns and butter”. That is, spending on military assets to protect the country borders v/s spending on consumer goods to raise the living standard of its citizens.
Similarly, we all face trade-offs in our daily lives. For example, whether to devote our next one-hour studying or watching Netflix? Whether to spend our savings on a vacation or buy a new car? Whether to work at a part-time job or focus on our college study?
The fact that we confront trade-offs is not enough to zero-in on a prudent decision. We must be well aware of the “opportunity cost” of every alternate course of action. Opportunity cost is described as what has to be given up to obtain an item. To spend one hour watching Netflix, we have to give up one hour of intellectual enrichment. To go on a vacation, we have to give up the brand-new car. To earn extra spending money through part-time, we have to give up studying which might earn us better grades.
THE THEORY OF CONSUMER CHOICE
The theory of consumer choice analyses how a person allocates his/her resources, that is, income between two goods. They are applied to compare the consumption pattern of the two goods simultaneously.
INCOME EFFECT AND SUBSTITUTION EFFECT
The impact of the change of price of any product can be classified into two effects, namely, income and substitution effect. Income effect says that if the price of one good falls, the consumer has greater purchasing power. In effect, they are richer than before. Hence, the consumption of both the goods will increase. On the contrary, there is a substitution effect which has a different way of approaching the situation. If the price of one good fall, it is now cheaper than the other product. So, our rational self will tell us to buy the cheaper good more than before while reducing the consumption of the other (apparently more expensive) item.
These concepts are generally used in predicting the consumption pattern in response to price fluctuations both by corporate firms in sales as well as the government to incentivise the public.
This theory of consumer choice also finds application in our day-to-day lives.
It can be applied to know how a person allocates time between income(work) and leisure. When we get a pay hike, we might think that a handsome amount of money can be earned if we spend more time working and sacrifice a few hours of leisure. So, income increases substantially while leisure time decreases slightly. This is an example of the substitution effect.
On the other hand, one might also think that because their salary has increased, they can still earn more than before even if they work for lesser hours and spend more time in leisure activities. So, our income, as well as leisure time, increases in this case. This is an example of an income effect where the consumption of both the goods, that is income and leisure, goes up.
Andrew Carnegie was an American steel industrialist who became the richest man in the late 19th century. He warned that “the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.” Carnegie perceived the income effect to be much stronger than the substitution effect on labour supply. Not much surprisingly, he gave away most of his fortune to charity during life as well as at his death.
There is yet another implementation of consumer choice theory other than work v/s leisure.
It is also applied while deciding how much of income to be consumed today and how much to save for the future. The amount one will save depends on the interest rate.
When the interest rate rises, we may tempt to save less than before. Nevertheless, that smaller amount will generate larger interest than earlier. Our present consumption will rise and the portion of our income that we save will fall. In contrast, we will want to save more, expecting to generate even greater interest for our future. Current consumption will be lesser than the prior one.
Behavioural economics is the study of the economic decision-making process and how it is influenced by psychological, emotional, cognitive, social and cultural factors. This is a relatively new field of study as counters the traditional assumption in economics that all individuals are rational and make decisions aimed at maximising utility.
GAME THEORY & THE PRISONER’S DILEMMA
Game theory is the analysis of strategies in a competitive situation where one player’s (participant’s) outcome is significantly affected by other player’s choice of actions.
The prisoner’s dilemma is the typical example used to describe a game (competitive situation) where individuals are inclined not to cooperate even when the results align with their mutual best interests. It was originally formulated by Albert W. Tucker.
The prisoner’s dilemma:
Two robbers are arrested and imprisoned in isolation. They are urged to confess. Following is the proposal which is kept in front of them. If A confesses while B remains silent, A will be let free while B will have to serve serious time in jail (10 years). Vice-versa if B confesses and A chooses to be silent. If both confess, then the sentence period will be made 5 years for both of them. Finally, if both remain silent, both go to jail for 1 year.
Prisoners are unaware of what his partner decides to do. Plus, each of them is concerned more for their personal freedom than the well-being of the other. So, the dilemma that prisoners face is that confessing is better than remaining silent, no matter what their partner does. Naturally, both will choose to confess. But the outcome when both stay silent and cooperate with each other is better than going for non-cooperation.
This manifests that individuals do not always make rational decisions. Also, the choices do not maximise utility and hinder the collective welfare of all.
A real-life example of this theory can be found in the recent Coronavirus pandemic. During the lockdown, there were predictions of a pending shortage in essential supplies due to the production or supply chains being affected. Everyone started hoarding groceries and other goods to be at the safer side. This behaviour can be explained using the example of a prisoner’s dilemma. People assumed whether the other person buys in bulk or not, he or she is always at an advantage to stock all the necessities before-hand. This led to an actual shortage in the markets and a frantic chaos among the people. If we would have cooperated with each other and didn’t choose to panic-buy, the shortage could have been well dodged. The anticipation of the “perceived” shortage led to an “actual” shortage.
At the end, we all are affected by macro-economic factors like inflation, unemployment and recession. Thus, economics extends to large scale administrative levels as well as has its presence in the fundamental day-to-day decision-making affairs.
References and Further Study
Principles of Economics, Mankiw (2017)