Sunday, 16 December 2012

The most important economic paradigm is not mathematical. The fundamental economic difference between assets and expenditures lies in the use we give to each item. Do not fall into the trap of wrong assumptions

Thick books full of equations deter most people from learning economics. The suspicion that there might be something wrong with the whole science is not unfounded. Otherwise, if economists are so knowledgeable, how do you explain that many of them are not wealthy?

Every course on economics begins with the law of supply and demand, which is considered the baseline of the science. This principle teaches that consumers buy fewer units when prices are high, but that on the other hand, when prices are low, for the same amount of money, you can get much more.

Since people have been acting in this way since the beginning of time, one might wonder if such wisdom justifies the cost of taking an economics course. My answer is rotundly positive. No matter how simple principles look, their applications demand subtlety and can lead to many blind alleys.

When it comes to applied economics, the most important paradigm is not mathematical. Understanding it can help you make better decisions and, above all, avoid many traps in your private and business life. If you choose to study only one thing about economics, let me suggest that you learn to tell the difference between consumption and investment, in particular:

1. Investments are not characterized by a high acquisition cost. A large house on the beach that you buy to spend your summer holidays every year can be expensive, but is not an investment, since it does not produce you any income. In comparison, a small low-cost apartment that you rent out to tenants does constitute an asset.

2. Investments are not defined by their long durability. A refrigerator that you purchase for your kitchen may last 10 years, but does not generate you any income. Such acquisition is not an investment. In contrast, a set of liquor glasses that may last 3 years is an investment if you buy them for use in your restaurant.

The lesson is that the aspect that creates the distinction between consumption and investment is psychological. Classifying buildings automatically as investments without considering their purpose may lead to wrong decisions and expensive errors.

The fundamental economic difference between assets and expenditures lies in the use we give to each item, not in the accounting rules regarding depreciation and tax deductions. A laptop computer to play video games is a consumption item, unless you get paid for playing those, for instance, because you write reviews for a video-games magazine.

The consequences of this principle are wide-ranging and encompass all fields of our lives. Being conscious of the difference can help you, for instance, to buy your clothes more efficiently, to discard worthless investment proposals quickly, and to reduce the cost of starting your own company.

Misunderstanding what truly constitutes an investment results in the waste of enormous sums of money every year. Do not fall into the trap of wrong assumptions. Not every big-ticket item is an asset and not all inexpensive purchases are consumer goods. When you make decisions, you will be much better off if you weigh each element according to its veritable nature.

For more information about rational living and personal development, I refer you to my book about how to be rational  "The 10 Principles of Rational Living"


[Image by insane photoholic under Creative Commons Attribution License. See the license terms under]