Every morning we wake up from bed we are faced with numerous economic decisions and choices in every facet of our lives. From whether to go to school or otherwise, to go to work or start your own business, whether you should accept that mortgage loan or otherwise, whether to pick up a course in economics or remain conservative in your accounting field and a host of others. All of life is all about economics. As individuals we are all economic agents, since there is no way we can live life without the fundamental principles and concepts of economics at play. We employ the principles of Economics every day, both consciously and unconsciously and a lot of people go bankrupt not because of anything but simply because of wrong economic choices.
At the heart of every economic decision, welfare maximization should be the prime motive. Choices that do not maximize welfare seldomly interest economists in anyway. Welfare maximization could be at the personal, family, business or even societal level, depending on the scope and horizon of the decision(s) at hand.
There are always several factors to consider when making economic decisions. In this article, I seek to introduce the reader to some of the basic concepts economists apply in economic decision making.
The first concept to talk about is that of rational decision making at the margin and utility. Rational decision making at the margin simply implies that we make careful considerations to ensure that every additional decision or choice we make is one that has the potential to make us better off and not worse off. Many at times, making good decisions and choices requires time and information. The extent to which we invest time to gather information determines the quality of our decisions and choices.
Utility is also defined in economics as the satisfaction an individual obtains from consuming a good or a service. It refers to the impact of our own economic choices on our lives – whether positive or negative. Utility is arbitrarily measured in utils.
As individual decision makers, our goal is to ensure that we derive the highest level of utility from every decision we make and this may come from several sources including a pay rise, extra family time, a nice outfit or a nice haircut. These are all things that makes us happy as individual economic agents. Economists particularly belief that at the personal level, individuals are intelligent beings, hence, will always make those decisions and choices that are in line with their best interest given time and information, irrespective of their level of formal education.
To say that people behave rationally means they do not deliberately make choices that makes them less happy or less satisfied and rational decision making does not mean that individuals are selfish either. The rational self-interest of an individual may include the welfare of his family, friends, neighbors and the poor.
The next concept to talk about is Risk Management. Personally, I’m of the believe that when it comes to risk management, insurers are the best guys to learn from. In my opinion, no other professionals does it better than they do. Risk is the next most important factor we need to consider when making economic decisions and choices. It refers to any situation where the likelihood of loss exists. Hence, when it comes to risk it is essential that we focus on minimums and not maximums. The three rules of risk management to consider are:
Never to risk more than you can afford to loss
Always consider the odds (anything can happen) and
Never to risk more for less (big money is made only when little is risked)
Whiles some individuals are risk “lovers” and always want to test the waters, others are averse to taking risks. Your duty as a decision maker is to identify your level of risk tolerance. Risk averse individuals have a lot of fear for the unknown and so want to always play it “safe”, they don’t want to be over extended financially. It is said that the familiar path is easy but the uncharted path is lined with uncertainties and risk averse folks always want to do away with uncertainties.
Risk “lovers” on the other hand dare to take a step. They hate playing it safe and being in their comfort zone. In addition, they aren’t bothered with decisions and choices that overextend them financially. Their attachment to risk is mostly motivated by curiosity. These are all personality traits possessed by different individuals and it is essential that you identify your own response and unique traits towards risk.
Making economic decisions in the face of risk minimization vis-`a-vis utility maximization can be quite difficult. In the sense that it usually entails more complexities due to the tradeoff between risk and present welfare. Assuming all else equal, the higher the risk we take today, the lower our present welfare might be, but we stand to gain in the future. Conversely, the lower the risk we take today, the more comfort and welfare we might enjoy today, but stand a lower chance of increasing our welfare by a greater margin tomorrow.
Additionally, risk is often directly related to yields or returns in virtually all investment models – the higher the risk of an investment portfolio, the higher the returns and vice versa. For example, investing in asset class like stocks, precious metals, indices and currencies often comes with higher returns but relatively more risky as compared to assets class like Government treasuries, mutual funds and fixed deposits, where the investor faces almost zero risk.
However, it is essential to note that taking higher risk today does not always guarantee that we will be better off tomorrow.
The magic bullet that separates economists and actuarists from all other decision makers is the understanding these professionals have about the concept of adverse selection.
Adverse selection is a problem that insurers and individual decision makers always have to contend with. It is prevalent primarily due to information asymmetry – Economic decision makers often do not have access to all the relevant information they may need at the time of making decisions. It is a market situation that arises when buyers and sellers do not have equal amount of information about a product or a service.
Typical examples of adverse selection in insurance occurs when a health insurance premium is sold to a sicklier. Which may happen when the insurer is unable to have access to the correct medical history of the insured probably due to falsification of medical history by the insured during the purchase of insurance premium. Also, selling life insurance premiums to persons involved in highly risky jobs is an example of adverse selection in insurance.
In managing risk, there is the need to ensure proper estimation of losses such that we do not under-estimate or over-estimate the maximum possible loss of our decisions and choices. This is what good economists and actuarists have mastered to do. When we properly estimate the possible loss and prepare for them (make room for them), we are managing risk effectively.
Time Preference: another important item we need to consider when making economic decisions and choices is our individual time preference. Like risk, time preference also varies from persons to persons. While some folks are present oriented and want to consume now, others are more future oriented and want to save now and consume later. Your goal is to ensure that your economic choices are in sync with your time preference. There is nothing wrong in being more present oriented – having the desire to consume more today and less tomorrow. It is all a matter of perspectives and individual expectations and these two variables differ on a case by case basis.
Additionally, we must consider the kind of priority we place on individual economic projects. Is it something that needs to be done now? Does the project need immediate attention? Then of course, resources must be set aside to do it now. Highly prioritized projects requires that we are willing to make the necessary sacrifices to get them done!.
Before I draw the curtains down in today’s article, let us consider a hypothetical example of a typical household who is faced with the economic situation below. Consider yourself in this same economic situation as well, and based on our discussion today decide the best decision and choice that will offer you the most optimal level of satisfaction.
Mr. Quansah is a business man. He produces and distributes brown sugar in the Central Business District of Accra. Mr. Quansah has two automobiles, one is a none-faulty Toyota Camry, 2012 model worth GHS 30,000 and the other one is a six months garaged-packed vibe Pontiac 2008 model he had acquired at a cost of GHS 40,000. Apparently, the engine of this vibe Pontiac is not functioning and needs to be replaced, aside several other minor faulty hitches that needs to be repaired.
Due to the nature of his business (producing and distributing brown sugar all by himself), Mr. Quansah is more interested in having a bigger and a more spacious automobile such as the vibe Pontiac so that he can use it to distribute his brown sugar to his customers after production. He desires to offer one of his automobiles for sale and finds a buyer who is willing to buy the Toyota Camry at price of GHS 25,000 and the vibe Pontiac at a price of GHS 20,000. Over time, Mr. Quansah has realized that all potential buyers who approach him for the deal quote him these same price ceilings.
Mr. Quansah is therefore considering to act from among one of the following alternatives:
Sell the Toyota Camry and use the proceeds to get the vibe Pontiac fixed
Sell the vibe Pontiac and use the proceeds to buy Government of Ghana treasury bond at a rate of 15% per annum compounded quarterly to buy a new one while driving the Toyota Camry
Sell the vibe Pontiac, sell the Toyota Camry and use the proceeds to acquire a brand new automobile of his choice.
Given this scenario, considering our discursions above and the situation surrounding Mr. Quansah, how should we advise Mr. Quansah on the above options? Which of the options above will optimize the welfare of Mr. Quansah and take his business to the next level over the medium term at a reasonable risk level? Lastly, which option will be more suitable for you?
SUGGESTED / RECOMMENDED ECONOMICAL APPROACH
All options have risks embedded. Based on time and risk tolerance individual choices may vary. But the one that is most likely to give Mr. Quansah the best shot of optimizing his welfare and boosting his business profitability over the medium term is the third option. And over the long run, he is still better off with the third option.
If you are currently bemused about an economic decision you need to make given the economic situations surrounding you, save yourself the stress. Consider talking to a professional today!
Author: E.O. ESSIEN
Email: elijahotoo.eo@gmail.com (0240080104)
