Most of us might understand the field of Economics as revolving around the study of the financial markets and the economy of a nation or the world. While that’s true, the fact is, many of the fundamental concepts in Economics also are also relevant and applicable on a personal level.
Just like the economy, we have limited resources and limitless wants – and learning how to make decisions around scarcity forms the fundamental concept of economics. Applying concepts from Economics, which study how people and markets make decisions about how to allocate resources efficiently, can be instructive in helping us get better outcomes in our personal finances.
#1 Opportunity Cost
Opportunity cost is the utility you’re missing out by choosing a certain course of action. Every life decision we make comes with opportunity costs. For example, choosing to further your studies after graduation would mean forgoing a few years of employment income and the possible career progression from starting work earlier.
Being aware of opportunity costs can help you make better financial decisions instead of just following standard advice. For example, most people will assume that buying a house is a good financial decision. However, sometimes, renting is a better choice. Being aware of the opportunity cost is important because you know the potential downsides of making that choice.
Even a decision to not decide has an opportunity cost. If you put off investing because you either have no time to do so or cannot decide between the different investment strategies, investment products and/or the brokerages to use, you are also paying a cost: your money are not being invested and taking the advantage of compound interest over time.
#2 Sunk Cost Fallacy
Sometimes we hold on to things and even ideas that no longer serves us because we have already put in so much into them. This is sunk cost fallacy.
This is important especially for investments because as your life circumstances change, you need to re-evaluate your investment strategies and perhaps invest more or divest certain investments. For example, most people have difficulty in surrendering or terminating insurance policies that no longer fit their life circumstances because of the insurance premiums that they have already paid.
#3 Law Of Diminishing Returns
In life, we tend to expect results if we put in effort. However, the law of diminishing returns reminds us that there is the point where putting in more effort does not give us the same results as it did earlier.
For example, in the initial stages of investing, investing more capital and knowledge will quickly gain you an edge over your peers. However, once you have mastered the fundamentals and have good financial habits and systems in place, spending double the effort and time in investing may not get you double the investment returns.
In fact, spending too much time looking at your investments may be counter-productive if you become obsessively worried.
#4 Marginal Cost Of Production
Conversely, the marginal cost of production states that past a threshold, it actually costs less to produce something. This ties in with the law of diminishing returns. The threshold for your investment knowledge to be productive is when you have mastered the fundamentals and have set up good financial habits and systems. Past this point, it costs you less in terms of incremental effort to produce the same results.
While it may be very difficult to start a side hustle such as an online store or freelance work, once you have established yourself, the next sale or contract is not as difficult to achieve as getting your first customer or client. This is the marginal cost of production at work.
Externality is the cost or benefit that affects a third party who did not choose to incur that cost or benefit. In life, it may not be easy to define who is a third party in any interaction, but some decisions can have unintended effects.
For example, having good financial habits and systems may have a positive externality of a better relationship with your spouse because you are no longer stressed about finances.