Core Principle 1 - The Cost-Benefit Principle - The Pros & Cons

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to think like an economist.
I love thinking like an economist because at the end
of the day, I think that's why I'm such an optimist.
Economics gives me hope.
Welcome to Think like an Economist with me Betsy Stevenson.
And with me Justin Wolfs.
This is the podcast where you learn how to well
think like an economist. You'll make better decisions about all
parts of your life, big and smile.
Learn to think like an economist, and you'll have the
tools that you'll need to help with life's big decisions.
Should you buy a home or keep renting, Should you
stay in your job or is it time to look
for better opportunities, And also for the everyday decisions such
as where that I have one more cup of coffee.
We'll hear from entrepreneurs, students, parents, and policy wonks who'll
help guide you whether you're making decisions about your career,
your free time, or even your love life.
You see, when you learn to think like an economist,
you'll basically live a better life. So let's get down
to it. Journalist and former economics student NaSTA and Tabacoli
far is joining us, and this week we're going to
start talking about the fundamentals what we call the core
principles of economics.
Hi, Betsy, Hi, justin. So this is a really big
and exciting mission that you guys have with this podcast,
and I am super excited to basically transform how I
think about things and how I live.
So we're going to get through what we call the
core principles. Betsy and I believe that thinking like an
economist can be boiled down to four big ideas that
together form the building blocks of good decision making. The
secret to economics isn't learning these principles, it's learning to
apply them.
So what are the core principles?
Yeah, so we'll quickly list these for you before delving in.
We have the cost benefit principle, which is really just
a supercharged version of the idea that you should look
at the pros and cons of any situation or any
decision you make. We're going to focus on that principle,
the cost benefit principle in this episode.
Next is the opportunity cost principle. That's where we look
at the next best alternative. So what would I choose
to do if I didn't buy a coffee? And let
me say, I really like coffee.
Maybe not as much as I do. Okay, let's move on. Next,
we have the marginal principle. Now, this one helps you
decide about quantities such as how many cups of coffee
to drink or how many hours to work. I mean,
you can even apply to how many hours you rest
or play, but it's essentially answering the question how many.
And the final one is the interdependence principle, which is
about how all our decisions are interconnected. You know, if
I decide to drink more coffee, that's money I can't
spend on tea. If I drink more coffee, it leaves
less for U NAS and it will also impact the
market for related goods like milk or sugar, not to
mention the effects on global trade flows as most coffee
comes from overseas. You see, everything's connected, So.
This is interesting because you're talking about a really wide
range of decisions from coffee versus tea, which is a
really important decision we all make all the way to
figuring out things such as how much to work, which
is about concepts such as income and labor and the
sorts of big things we think about when we hear
the word economics.
That's the point. Nas When you think about whether it
work an extra hour or day, you're making an economic decision,
and when you're deciding to have one more cup of coffee,
you're going to follow a pretty similar thought process. The
steaks might be different, but they're the same in terms
of the actual decision making process.
Economist Mary Daily tells us that thinking like an economist
is what has helped her understand people and the world
around her.
Hi, I'm Mary Daily, President and CEO of the Federal
Reserve Bank of San Francisco, and personally, I think everyone
should think like an economist. I know it helped me.
It helped me understand people. People confused me. They still do,
but at an early age I knew this was true.
And what economics did is it gave me a way
to understand people, a way to understand that They're responding
to motivations, incentives, things that are important to them that
I may not even see. And then unless I ask questions,
and unless I understand that context, I can't actually understand them.
And I started asking questions about why do we do
what we do? And that's why I love thinking like
an economist because at the end of the day, I
think that's why I'm such an optimist. Economic Next gives
me hope.
Thinking like an economist is really about the thought processes
rather than what you're deciding about, and that's what makes
it so powerful. Once you learn to think like an economist,
you'll see opportunities to apply the skill everywhere, and it
can better help you understand others. Mary Daily argues that
people are responding to incentives and motivations that we might
not even see. That's the subject of today's episode, the
cost benefit principle.
So this sounds a little bit like pros and cons perhaps, well.
Yes, though it's a bit more refined than that. For
every decision, there are benefits and costs, and you should
choose something if the benefits of that choice are more
than the costs of making that choice. And you can
apply this to pretty much every decision you make.
Okay, let's start with a really obvious example. So the
benefit of listening to this podcast right now is that
you'll learn how to think like an economist.
And it's a huge benefit.
It is a huge benefit because you're going to make
better decisions and transform your life. But the cost is
I mean, I guess it's the time you're going to
spend listening to.
This right so you could be watching TV. Yes, you
can apply this principle to just about anything. You'll use
it when thinking of which career to pursue, or even
thinking of whether you should buy a cup of coffee.
What you need to remember is that you should choose
something only if the benefits are at least as big
as a cost.
Okay, so let's stick to this example of buying a
cup of coffee, because I think a lot of people
listening now have maybe had to grapple with this decision
earlier today. So the benefit of a cup of coffee
is the enjoyment you get out of drinking the coffee,
and I guess the cost is literally the money you
have to pay to, you know, buy this coffee. So
these these seem like slightly different things though the benefits enjoyment,
the cost is a sum of money. So I mean,
how do we compare enjoyment to money to figure out
if the benefit exceeds the cost.
Well, what we want to do is put everything on
a common scale. So let's convert everything to dollars so
it can make more sense. Now, Now, as you sound
a little skeptical, but it's possible to put a price
on your enjoyment of coffee. And that's how we do that.
So let's ask how much are you willing to pay
for a cup of coffee?
So I'm not much of a coffee fan. I'm a
really big tea drinker.
Well this is interesting, as I really like coffee, and
I'd probably be willing to spend more on a cup
of coffee than you.
Coffee's okay, it's a warm drink, it's not bad. I'll
probably spend up to a dollar maximum on a cup.
Right, Like, if that was your only choice.
It's better than nothing. I'm willing to pay up to
a dollar for a cup of coffee.
I'm more likely to spend up to four dollars on
a cup of coffee. So if I show up at
a coffee shop and they're selling coffee for three fifty,
I'm willing to pay up to four dollars, So I'm
clearly going to buy that cup of coffee for three fifty.
Now you probably would have passed on it, nas yes,
because that right, it's more than you're willing to pay. Look,
the benefit of a cup of coffee has nothing at
all to do with the price. The benefit is simply
an expression in dollars of how much joy the coffee
brings you. So it could be helpful to think about
the benefit before you take a look at the price.
Okay, so bertsy. This makes a lot of sense, but
it sounds kind of like sort of cold rational economics.
I like to think we're more romantic about the joy
someone gets from a delicious cup of coffee.
Look, it's just not that ruthless. Money is simply a
measuring stick. It's a way we can put the benefits
and the costs into the same units. When they're in
the same units, that gives us the tools to take
account of all the aspects of this choice. Look, as economists,
when not obsessed with money, it's just a useful measuring stick.
I like to say that economists are no more obsessed
with money than architects are with inches. It's just how
we measure things, and by using this measuring stick, we
can take something non financial. This is your point about
being romantic, the joy you get from a cup of coffee,
and compare it to the costs. This simple trick means
that we're no longer obsessed with just the financial stuff.
We can take account of all the costs and all
the benefits, not just those that come with a price tag.
Betty likes coffee, Nas doesn't, and you've clearly shown that,
and how much you'd each be willing to pay for
a cup of Joe And.
The cost benefit principle doesn't mean you're selfish either, Nas,
you don't like coffee, but what if you were meeting
a friend who.
Does so I would be happy to spend more than
a dollar for my friend's coffee because sure be enjoying
it and that will make me happy. And also we're
meeting up to hang out, so it's not really about
the coffee. It's about maintaining the friendship and that is
worth more than a dollar to me.
There you go, So remember you should be thinking of
this question. What's my willingness to pay. How much am
I willing to pay if my friend to have a
cup of coffee? So they're happy and we're happy and
we're all hanging out.
You have to remember to think of the full set
of and the full sets of benefits. For me, coffee
in the evening starts to become a cost, and then
I won't get a good night's sleep. That's why I'm
not going to spend four dollars on a cup of
coffee in the evening, but I will pay four dollars
for a cup of coffee first thing in the morning.
Also because I really want to make it clear that
thinking like an economist is not selfish, ruthless, or cold hearted.
We need to remember that everyone benefits when we apply
the cost benefit principle. Betsy buys a cup of coffee,
she's happy, the cafe sells it to her, they're happy.
Betsy wants the coffee, the cafe wants a cash. It's
a win win.
So this all sounds really straightforward. Are there any tips
or words of caution?
Yes, you have to be really careful that other factors
don't cloud your decision making, and you need to focus
on the cost and the benefits. A common pitfall is
that people will be influenced by how oh something is
sold to them. For example, people might be more likely
to buy something they don't really want simply because it's
on sale. They buy a lime green sweatshirt that's sold
by a big brand name company and was on sale
for twenty five dollars, down from the original price of
one hundred and ten. They think they're getting a bargain
as they've seen the price drop, But did they really
want that green sweatshirt in the first place enough that
they'd be willing to spend twenty five dollars on it.
This is called the framing effect, and we've all fallen
for it. Marketers use it all the time to try
to fool you into buying stuff, even when the benefits
are less than the costs. You sometimes see this at restaurants.
The laddin outrageously expensive item on the menu, say a
fancy lobster, and even though no one ever buys it,
the point of the lobster is to make all the
other stuff on the menu look like a biogon buy comparison.
But the truth is, even if there's a sixty dollars
lobster on the menu, it doesn't make a twenty dollars
hemp or a bargain. You really need to focus on
if you want each individual dish in the first place,
and how much you want it.
Okay, So let's say I'm looking at this menu and
I see a goat's cheese salad which looks pretty good.
How would an economist help me decide whether I should
order this salad or not.
One trick to avoiding the framing effect is to ask
yourself first, how much am I willing to pay for
this coat cheese salad? Only after that should you look
at the price or the rest of the menu. You
only want to order the goat cheese salad if the
price is less than what you're willing to pay. The
price at the lobster, the price of the steak, and
whether it's on sale all irrelevant.
Okay, So I really want us to really understand this.
Is that a more complicated example we can go through.
Well, let's go with whether it makes sense to buy
a car or not. That's a big decision a lot
of people have to make.
Yeah, now, is that something you've ever wrestled with, whether
you should own a car or not?
Yeah?
So I did briefly own a car, and financially it
didn't make sense. But I really loved the car, so
it was it was really difficult to give it up.
Yeah, I think that it's a mistake people often make,
either buying a car or hanging onto a car. They're
emotionally attached to the car and then they try to
make fake financial reasons for why they should keep it.
That's a benefit we should definitely take into account. But
let's not fool ourselves about the rest of the math.
So how should we work through the question of whether
it makes sense to own a car?
Okay, so it's time to dust off the cost benefit principle.
So now let's go through some of the cars you've faced.
Hanging onto the car, so I was.
Probably spending about one hundred dollars a month on gas,
and parking is really expensive, So that was about twenty
dollars a day. That'll be one hundred dollars a week
if I'm working five days a week, and so we're
looking at four hundred dollars a month for parking.
So you've got five hundred dollars a month that you
were spending on gas and parking. What about insurance? And
maintenance and all those sort of other costs. Did you
ever think how much you were spending just on upkeep
of your car?
Yeah, I think the last year I had it, it
came to maybe just under two thousand dollars, So that's sort.
Of ballpark, so round about another two hundred bucks a month.
So take your previous five hundred at two hundred or
seven hundred bucks a month costs.
I can't see why you might have started to think
about whether you should hang on to this car. What
did you use the car for? What were the benefits?
So I used to use it for going to work,
and you know, it's nice on my back not to
have to carry everything with me, and then yeah, it's
just I just enjoy driving. And it also meant that
I could go for a drive on the weekend or
you know, do kind of things like that as well.
So here's one way of thinking about the benefits. What
if you'd taken an uber or a taxi for every
one of those rides? How much do you think that
would have cost you?
If I had to uber to work, it's probably about
thirty dollars a day. So if we're thinking I'm working
twenty days a month, that'll be six hundred dollars a month.
Okay, So the benefits of buying a car is that
you can save six hundred dollars in UBER fees, and
the costs is it's going to cost you seven hundred
bucks a month. Nows, weigh it up for me, do
the benefits of buying a car acceta costs?
They don't. But but I did really love the car.
But no, on a rational, rational scale, no, it doesn't
make sense to.
Have a car.
So if you follow this logic, Nows, you could save
one hundred dollars a month right there by taking more
ubers and not buying that expensive car.
So I think a lot of people think the idea
that you would take an uber or take a taxi
is really indulgent. And I think it's really important for
people to be able to just do the math and
figure out whether when they do something like buy a car,
they're going to yield a stream of benefits for themselves
that are at least as big as the stream of costs.
For some people, the math is definitely going to work
out they should go out and buy that car. But
for other people it's not indulgent to take uber or
taxis it's actually cost savings.
Now I feel less bad about letting go of my beloved.
Car, and that is the beauty of the cost benefit principle.
So we've just gone through the cost benefit principle. Let's summarize.
The cost benefit principle reminds you that any decision you face,
there's going to be benefits and they're going to be costs.
And if you want to make a good decision, you
want to tally up all the benefits and all the
costs and only do things where the benefits are at
least as big as the costs.
And the key part to what Betsy said there, don't
forget it's all the benefits, not just the financial ones,
all the costs, not just the financial ones. You don't
have to be selfish when you apply this, but you
do have to be systematic.
And is there anything we can stop practicing.
Over the next few days, as you find yourself making decisions,
pause for a moment and ask yourself why you're making
the choice you're making.
Really think, and I bet you'll discover that it's really
about costs and benefits. Perhaps you'll discover that subconsciously you're
really following the cost benefit principle, and in the.
Next episode we'll come back and talk about the costs
that people sometimes overlook.
Cool, okay, so we'll speak to you all them.
Thanks Naz for joining us. I'm Betsy Stevenson, I'm Justin Wolfers.
Thanks for helping me to think like an economist.
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