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The Myth of Economics

Economics is one of the most rational and logical disciplines that’s widely used across the world. The study heavily emphasizes scarcity – the allocation of limited resources towards unlimited wants and needs. This factor can be extremely relatable for everyone; either that be in the form of labor, money, and even time, everyone practices economics whether they know it or not. Despite the practically of economics, it still manages to have some questionable aspects being taught within the discipline with many faults that still needs to be addressed.

Ceteris Paribus

Aside from the laws of supply and demand, one of the very first things you learn about in Economics 101 is the idea of ceteris paribus, literally meaning “holding other things constant” in Latin or translated as “all things being equal” in English. Ceteris Paribus is the dominant assumption that is applied by mainstream economics. This concept assumes that all other aspects are essentially frozen, with the exception of the variable you are focusing on. In practice, ceteris paribus is used to see the cause and effect when the focused variable is being changed.

As a very simple example, if you were looking to buy fruit from the grocery store and were indifferent between two selections of apples or bananas, and the apples cost $0.50 each and bananas were $0.25 each, you would probably decide to purchase the bananas because it is the cheaper option. But if you were to change the cost of the fruit, say because the vendor you are buying from had a large supply increase for their most recent shipment of apples, decides to do a promotion to help get rid of the excess. The vendor decides to sell five apples for a dollar, translating to $0.20 per apple. Due to ceteris paribus, apple is now the cheaper fruit and you decide to buy those instead of the bananas.

However, this is not the sole factor you would decide on in a real life situation. This method is a very simplified analysis but does not account for the condition of the fruit, if the fruit is organic, if you were purchasing these fruits to use as an ingredient, the nutritional factor, or even the environmental conditions that the fruits were being grown in. Not only do these components factor into your personal decision making on whether to purchase the fruits or not, but it also impacts the cost of the fruit due to large number of factors.

In a real world application, you will see economist mentioning one variable all the time. Whether that being how increasing interest rates will slow down the economy, high inflation rates hurting families purchasing power, or increasing the supply of housing would lower housing cost, many economist will focus on one variable, determine its cause and effect, and claimed to have figured out the answer to fix economic issues. In reality, this is far from how the world works; there are dozens of dynamic variables constantly changing, but ceteris paribus is the economist best approach to cracking these cases.

The Perfectly Rational Economic Man

The economic man, also known as Homo Economicus, is a mythical creature that is created within economics. Unlike real humans, this being is completely rational, has little to no self-interest, and makes their decisions in order to maximize its utility. As mythical as the economic man might be, this being is used as the human representative in economic models. The economic man, alongside ceteris paribus, go hand in hand with each other as you need the two to conduct analysis on economic models.

The primary concern the economic man has is how to maximize either profits or utility, depending on the situation. If the economic man in the economic model is a consumer, then their primary goal is to optimize their utility. If the economic man is the supplier, then in this case their primary goal is to maximize their profits.

As an example: you’re out at the store and decide to purchase a booster pack for a card game you played when you were younger. In that pack that you purchased included a ultra rare card with only 10 printed in the world! The nostalgia is hitting you hard as you realize the card has one of your all time favorite characters. You decide to check the value of the card and see that it’s upwards of $1,000! Do you proudly display the card in a vacuum sealed container at home or would you sell the card? What would you do if you were given the card by a friend who knew nothing about the value? Would you still consider selling the card knowing the value or keeping the card because it was a gift?

The economic man is not concerned with the external factors that do not influence the price of this card. In their eyes, they understand that the value is $1,000 and that is what matters. As a completely rational, logical, and profit maximizing individual, the economic man would sell this card for the $1,000 despite all of its sentimental value.

Economic Indicators

Economic indicators are important metrics that help policy makers, investors, and businesses gauge the health of the overall economy. Understanding the rate of inflation, interest rates, and sentiment allows for proper responses. But this can be difficult to do considering that economic indicators are lagging indicators.

Let’s consider the consumer price index (CPI) number that’s published every month by the U.S. Bureau of Labor Statistics (BLS). As a example, in the month of January, the BLS will release the CPI number for the previous month, December, while it collects date for the month of January to be released in February. Therefore the shortest time frame you would need to wait for CPI numbers is delayed by one month. If CPI numbers get too out of hand, the Federal Reverse might decide to step in and slow down the pace of inflation by lowering interest rates.

What about the metric that measures how well a economy is doing: the gross domestic product (GDP)? GDP numbers are calculated by the U.S. Bureau of Economic Analysis and released at the end of each quarter. Since there are three months in each quarter of the year, GDP numbers that get released at the end of each quarter are lagging by two to three months at a time. There has been debate amongst economist about this issue and how we should actually be measuring this number in a tighter time span, such as every two months or even as short as one. Their reasoning behind this is quite justified; a recession is defined as two consecutive quarters of negative change in GDP. If this could be identified sooner rather than later, the U.S. would not need to deal with pain and policy makers at the Fed or even Congress through monetary and fiscal policies, respectively, could deal with these early signs.

A Realistic Practice of Economics

Choice that are made using classic economic theory starts with three main assumptions: that all decisions are made rationally, the decision maker is trying to maximize their own utility, and that the decision maker has a self-interest bias. However, it’s difficult to be used in practice because humans in generally are emotional creatures. We do not only base our decisions based on what’s best for us; but we also make our decisions that make use feel satisfied emotionally.

In 2017, economist Richard Thaler won the Nobel Prize for proving that humans make predictable mistakes in a research that he jokingly called “Dumb Stuff People Do.” In this research, Thaler was able to show that human beings are unable to fully remove their emotions from making decisions, but being able to predict them can help you make better decisions. This field of study is now known as behavioral economics; a relatively new study that combines both aspects of psychology and economics to help understand how and why people make decisions based on what they should do and what they actually do. The research coming out of this field has been ground breaking, changing the way people conduct business, helping governments shape their public policies, and much much more. If you are interested in this topic, consider reading some of his books such as “Misbehaving: The Making of Behavioral Economics” or “Nudge: Improving Decisions About Health, Wealth, and Happiness.”

Fun fact: the name of this blog came to me through the idea of the Economic Man. This creature that makes ultra calculated moves by trying to perfect everything. In contrast, we have the more realistic ideas coming from behavior economics telling us that we as decision makers don’t really understand at all what we really want. I’ve come to acknowledge and embraced this, which is why I consider myself a simpleton.

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Behavioral Economics, Economics

Dissecting The 50-30-20 Budgeting Rule

What is the 50-30-20 Rule?

The 50-30-20 Rule is currently the most popular budgeting method around. It’s the go-to allocation breakdown you would generally get if you were to get personal finance advice. In a very quick TL;DR sense: the 50-30-20 Rule splits your income into three different categories – needs, wants, and savings + debt. However, it is important to note that the number you will be working with is after-tax income and to remove any other payroll deductions from this number such as your 401(k), health insurance, and any other payments that have been automated.

50% of your income will be allocated for needs. This means that 50% of your income will be going towards expenses that are seen as necessities. These would include:

  • Housing
  • Utilities
  • Food
  • Transportation
  • Insurance
  • Minimum loan payments

If your spending in this category is above half your after tax income, you might want to dig a little deeper into what you can avoid or downsize. This can be in the form of buying the off brand grocery items, cutting your own produce vs. pre cut produce, look for smaller housing, making sure that lights and appliances are off when you’re not using them, drive a modest car, or decide to carpool with co-workers or take public transportation.

30% of your income will go towards your wants. The difference between your needs and your wants are that your needs are seen as things you can not survive without. On the other hand, your wants could be described as things that aren’t essential to your day to day survival. Generally wants are things that make your life more fun. These would include:

  • Entertainment
  • Clothes
  • Eating out
  • Date nights
  • Gym memberships
  • Traveling
  • Monthly subscription plans
  • Premium plans

The spending in this portion of your budget can get out of hand if you do not watch it closely enough. In the case that this category goes over or if you find yourself hitting 30% much quicker, consider going for items and services that are one tier lower than the ones you are currently picking. If you’re getting the large consider getting the medium instead. If you’re going for the filet mignon or ribeye consider the sirloin. Alternatively, cut back on the days you decide to go out.

20% of your income should be going towards your savings and debts. Savings is an important aspect of your financial health since it can help you for any unforeseeable situations that might come up. It’s also important to start saving for retirement early on in order to take advantage of compounding interest. On the same side of the coin, tackling debt as quick as you can is beneficial so you don’t rack up large amounts of interest for your loans. These would include:

  • Saving for a emergency fund
  • Saving for your retirement through either a Roth IRA, Traditional IRA, or 401(k).
  • Paying off your debt to make sure that your accumulated interest does not get out of hand

Financial professionals often say that you should have at least three to six months in your emergency savings account in case a unforeseen circumstance occurs. After this milestone has been reached, focus towards other financial milestones such as your retirement fund, brokerage account, car, house, vacation, or anything else that requires a large sum of money.

Though this 20% section of the budgeting plan includes debts, similar to the 50% section, this section focuses on extra payments which would eventually lower your total accumulated interest throughout the lifespan of any loans, therefore “saving” you money.

A step by step guide for applying the 50-30-20 Rule

  1. Figure out how much you’re actually taking home by calculating your after-tax income. This might be a little more tricky if you are working as a freelancer, but generally it should be what you earn per paycheck minus your business expenses and the amount you’ve put aside for taxes. If you’re an employee of a company, this should be easier to do. Assuming that you have enrolled into tax withholds and pre-tax deductions, such as insurance and retirement accounts, the check or direct deposit number should be the number you are working with.
  2. Categorize all of your expenses into three different sections: needs, wants, and savings + debt. Remember that your needs are the essential expenses for you to survive on a day to day basis. Your wants could be more luxury items and expenses. Savings are allocations of money that are meant to help you prepare for the future, either that be in a form of a retirement account or for a rainy day emergency fund. Debts are previous loans you have taken out in order to pay for a product or service: that could be student loans, mortgage payments, credit card debt, and car payments.
  3. Analyze your allocation of money and adjust it to fit the 50-30-20 Rule. Usually you would have one fixed cost, which is the allocation you put towards your needs. Though this percentage can change according to your job status (pay rise, job change, etc), you will primarily be focused on your wants and savings + debt. If the percentages for these two are lower or higher than 30% and 20% respectively, see what you can cut back on, or ideally, how to maximize these two portions.

Alternatives to the 50-30-20 Rule

It’s also important to note that even though the 50-30-20 Rule is generally the most well known budgeting allocation, there are other budgeting methodologies out there. This rule was originally created in 2005 by Elizabeth Warren and Amelia Warren Tyagi in their book “All Your Worth: The Ultimate Lifetime Money Plan.” As of writing this article, this rule is 17 years old and only accounted for the average person. If this does not work for you, consider allocating your income into different percentages depending on your own personal situation, such as 20-40-40 or 70-20-10. Or even try other budgeting methods that will be more suited to your own specific needs.

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Finance, Personal Finance

Meet the Simpleton

It’s me – I’m the Simpleton. Someone that doesn’t really know much about anything but isn’t afraid to admit it. This blog is really meant for me to express my thoughts about certain topics of interest, exploration of hobbies that I aim to constantly improve upon, and anything else I feel like writing about. This blog will continuously be worked on so bare with me as I figure things out. With all that being said, please join me on my journey.

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