LET’S SAY YOU come into some extra money. Do you take the family on a great vacation or do you remodel that room you try to stop guests from seeing? To come to a decision, you might weigh the fun of the vacation against the pride of the redone room.
It’s at this point that some intrepid economist, risking his or her life-of-the-party reputation, would pop up and say, “You’re not doing it right.”
Economics is the study of choice—and the big engine for choosing is cost-benefit analysis. That’s what most people will tell you they do. In the above example, however, the economist would point out that the decision-maker is only really comparing the benefits of choice A and choice B, while ignoring the costs.
For instance, the cost of a vacation might include:
Meanwhile, the room remodeling might bring these costs:
It’s tricky to thoroughly balance out the costs and benefits of a decision, in part because the weight of each factor is totally subjective and personal. When I teach this to kids, I use a more student-oriented choice, such as deciding between watching TV and studying. First, we list the benefits of each choice, simplistically valuing each benefit as +1 if the benefit is liked and +2 if the benefit is liked a lot.
Benefit of doing schoolwork:
Benefit of watching TV show:
With the TV show at +6 and schoolwork at +5, it would seem the show wins. But this is only half the job. It’s only a benefit-benefit comparison. To do a cost-benefit analysis, the student must now list the costs of doing each and mark them as -1 (bad) and -2 (really bad).
Cost of doing schoolwork:
Cost of watching TV show:
How does this all net out? The total cost-benefit score of doing schoolwork comes to +1, once you subtract the -4 cost from the +5 benefit. Meanwhile, the net score of choosing the TV show is -1, once the -7 cost is subtracted from the +6 benefit.
Lo and behold, once you factor in the potential negative consequences, choosing to study has a higher value than watching TV, so it’s probably the better choice. Did you really expect anything different from a teacher?
In weighing two choices, what we’re actually weighing are the consequences of our choices. To be sure, in the above simplistic model, the probability of each consequence isn’t measured. Still, the principle remains: All choices have consequences and, to the extent we know them in advance, we should consider those consequences.
Usually, we simply do this sort of analysis in our head. The question is, are we thoroughly considering costs and benefits when making a choice? If we aren’t sure we’re being thorough—and it’s a big decision—we may want to list the pros and cons, and then assign formal numbers to each. It often doesn’t take long. We could probably get it done during the TV show’s next commercial break.
Jim Wasserman is a former business litigation attorney who taught economics and humanities for 20 years. His previous articles include Scenes From a Life, Changeup Pitch and Bored Games. Jim’s three-book series on teaching behavioral economics and media literacy, Media, Marketing, and Me, is being published in 2019. Jim lives in Granada, Spain, with his wife and fellow HumbleDollar contributor, Jiab. Together, they write a blog on retirement, finance and living abroad at YourThirdLife.com.