When Making Financial Decisions, Think Like An Economist
As we go about our daily lives, we are faced with having to make many different decisions about money. Each decision we need to make will affect our financial success. I offer you a mindset that if adopted, will help you to weigh and make better decisions with your money.
Consider opportunity costs
The opportunity cost of a decision is the value placed on the next best alternative that you are giving up. Using the concept of opportunity costs in your thinking will allow you to address the personal consequences of your choices, or what trade-off you need to make.
A trade-off is giving up one thing for another. For example, your choice to purchase the new movie release on Disney+ because you NEED to see it now, versus waiting for it to be offered for free on the platform.
More complex decisions may be the choice to either rent a place to live versus buying, buying a new versus used car, working or borrowing to pay for college, or starting early or late to save and invest for retirement.
Identify marginal utility and marginal costs
Marginal utility is the extra satisfaction derived from having one more incremental unit of product or service. Marginal cost is the additional cost of that one more increment of product or service.
Thinking about marginal utility and cost can help in decision making because it reminds us to only consider the variables we deem as most important. What will we really gain from our decision?
Assume you could buy concert tickets that were $150 per ticket that are in the upper level of the stadium. For $250, you could have tickets that are ground floor and close to the front of the concert. Which will you purchase?
What is the marginal utility that you will gain from making that decision? You could perhaps see and hear more from the more expensive seats. Would those extra benefits be worth it to you to pay the extra $100?
Factor in your marginal tax rate
Our financial decisions have an important impact on the income taxes you must pay. Your marginal tax rate is the rate at which your last dollar earned (not all your income) is taxed. It is the highest tax bracket that your taxable income puts you at.
As your income rises, you will pay higher marginal income tax rates. When considering purchases and what you can afford, don't just use your base salary and/or bonuses/commission that you earn as your basis for figuring out what you can afford. Understand that based on your income, your marginal tax rate, state and/or local income taxes, social security, and medicare all take a chunk of your income. What you are left with should be the number you use to make spending decisions.
Following this thought process will help to change your decisions from emotional and reactionary to well-thought out and rational. Start to implement the economist mindset into your thinking and decision making and you will start to build a clearer path to good decisions.