Fascinating economy

Short-Term Expenses

Fixed expenses cannot be avoided. They are part of life. The financial planning that takes care of these expenses is known as short-term planning. Short-term planning involves keeping track of and covering all fixed expenses such as food and rent.

Most consumers do not limit their budget to just the necessities. They also try to plan for flexible expenses like entertainment, gifts, trips, and unforeseen circumstances that are a regular part of nearly every consumer’s spending habits. Short-term planning allows consumers to have enough money to do some of this discretionary spending.

Securing Your Future

Short-term planning takes care of expenses for necessities and some luxuries. But most people have financial goals that go beyond just meeting their day-to-day expenses.

To prepare for spending in the years to come, many people employ long-term planning. This kind of planning involves looking into the future to make wise decisions.

Long-term planning can seem a bit overwhelming. It can be hard to plan for spending that you will not do until 20 years have passed. But long-term planning has many important benefits. Wise consumers try to think about the long-term plan even though it can be difficult to predict the future.

What is Your Plan?

How about you? Have you considered your long-term expenses? Have you started saving money for college, or maybe for a down payment on a car? These are two common reasons for long-term planning.

Assets and Income

When consumers plan for the future, they pay attention to assets and income. An asset is anything a person owns that has monetary value. Personal assets can include cars, computers, jewelry, or a savings account. Income is the money a person gets, whether as a gift, a salary, or earnings from an investment.

Knowing your assets and income is necessary in helping you plan your budget. This, in turn, will affect the way you spend your money. For example, you could decide to invest in stocks this year. Five years from now, you may show a profit on this investment. That extra money can help pay for tuition. This is an example of how long-term planning can be effective. You can plan now for how your assets and income might grow in the future.

View Assets and Income. Sort each example into the appropriate column to show whether it is an asset or a form of income.

Financial Planning and Decision Making

Consumers engage in both short-term and long-term planning. Without short-term planning, you might have fixed expenses that go unmet. Without long-term planning, you cannot move toward your bigger goals such as going to college, owning a home, and eventually retiring.

Both short-term and long-term planning affect how consumers make decisions. What consumers spend now often depends on their plans for the next month, the next year, and the distant future.

View Financial Planning and Decision Making. Sort the following financial goals into the correct column below to make sure you understand the difference between short- and long-term planning.

Consumers in the economy are a bit like runners in a race. The runners each have a different reason for competing. Some may be happy just to be in the race at all. Others may be intent on achieving a personal best, while for others only winning the race will do. All the runners take part in the race to achieve some sort of satisfaction. They run to find fulfillment. Consumers buy goods and services for just the same reason. They want to find satisfaction when they participate in the economy.

What makes someone satisfied? Of course, the answer is different for everyone. Some people are content with little, while others can never seem to get enough. As one of the richest men in the world, Henry Ford was once asked, «How much is enough?» He answered, «Just a little bit more.»

Some want to win, while others are happy to participate.

Utility

Satisfaction cannot be easily measured. But because nearly all economic decisions involve consumers in search of satisfaction, economists try to understand it. They call a person’s economic satisfaction utility. Utility is the amount of personal satisfaction consumers get from the goods and services they purchase.

For instance, if you buy a new CD and find that you really like the music on it, then you are satisfied. Your utility is high. If you do not like the music, however, you are not so satisfied. Your utility is low. The concept of utility applies to every decision you make when buying goods and services. It is an important factor to consider when looking at how consumers make decisions.

Remember that your measure of utility is quite different from that of others. Your utility depends on your personal tastes and preferences, your goals, and your individual situation. Someone else might love a CD that you did not like very much. Utility levels differ from person to person.

Some things can be weighed easily, but satisfaction is not one of them.

Utility and the Cost-Benefit Analysis

You already know that consumers use the cost-benefit analysis to make economic decisions. Costs and benefits can be measured in monetary or nonmonetary terms. Ultimately, costs are measured in satisfaction, or utility. Since each person’s utility is different, different people make different decisions in the same situation.

Consider this example. Mike and Emily are in the same physics class. They are both having a hard time understanding the material, so the teacher offers to help them catch up after school. The cost to each of them is a few hours at the end of the school day. While the time commitment is the same for both, their utility may be quite different. Emily has other after-school activities that she does not want to miss. Mike has no other plans after school. The cost of this time is different to each of them. Their utility is different.

Different decisions result from different tastes and preferences.

The Road Not Traveled

When you make decisions as a consumer, you do not consider just one possibility. For instance, if you are thinking about going to a movie, you are weighing two different options: going and not going. Not going leaves you other options: reading a book, taking a walk, or playing a game with a friend. Every decision involves following one path and not following all the other possible paths.

So, a decision is not just about selecting something that has more benefits than costs. It is about selecting the option that gives the greatest amount of utility from among all the available opportunities. Consumers have to consider the benefits lost as a result of their decisions.

Think of a farmer who decides to grow corn on his land. His opportunity cost is the alternative crop that might have been grown. What if he decided to grow wheat instead of corn? Would he have made more profit? Since he decided to grow corn, he gave up the alternative to grow wheat. He considered both options before making his decision, and in the end, he thought that it would be more profitable to grow corn.

Utility and Incentive

To maximize utility, consumers and producers look at incentives. These are the factors that motivate or influence human behavior.

Incentives can be monetary or nonmonetary. If you work very hard at your job, you might get rewarded with a bonus or a pay raise. Your employer is giving you a monetary incentive to work hard. If your hard work earns an extra week of vacation instead, that is a nonmonetary incentive. Because utility is a person’s satisfaction, an incentive can raise utility whether it is monetary or nonmonetary.

Incentives increase the possible benefits of a decision. As such, they affect the cost-benefit analysis a consumer might make.

Most people would agree that a bonus is a better incentive than a pat on the back.

What Drives You?

When you look at opportunity costs, you consider monetary and nonmonetary incentives.

If you reduce your part-time work hours to do volunteer work in your field of study, you will decrease your monetary benefits but probably increase your nonmonetary benefits. The volunteer work helps others and makes you feel good. This decision could also have a monetary effect; the experience you get from volunteering might help you get a better paying job in the future.

Untangling and calculating the monetary and nonmonetary incentives can be tricky. As a consumer, you do it all the time when you make decisions.

Marginal Analysis

Consumers try to boost their utility by making decisions that maximize satisfaction, or benefits, while minimizing costs. You have seen that cost-benefit analysis and paying attention to opportunity costs help consumers figure out what decision will be best.

Consumers also use marginal analysis when they make decisions. Marginal analysis helps answer an important question: What happens if the situation changes by one unit of something? Economic players ask themselves this question in one way or another all the time.

Consider this situation: The latest summer blockbuster has gotten some pretty bad reviews but seeing it will give you a chance to do something with your friends. Besides, tickets for a matinee are only $5. The utility you will receive from that purchase seems high.

But what if you get to the theater and discover that the ticket prices have been raised by $1? It might still seem worth it to go. But it is also possible that the extra dollar pushes the cost higher than the benefit. If that is true, then your utility has decreased, and you likely will choose not to go.

Will you see the movie for $6? How about $7? What about $8? At a certain point, the price will rise high enough that the cost outweighs the benefit, and your decision would change. That is marginal analysis.

Producers Thinking Like Consumers

Even though they may be unaware of it, consumers use marginal analysis when they make economic decisions. For every good or service, there is a point at which consumers change their minds about making a purchase if the price gets too high. Consumers are not necessarily aware of the fact that it was marginal analysis that led to that decision.

Producers, on the other hand, pay close attention to marginal analysis. They hope to maximize profits, which means they want as many customers as possible to pay the highest price possible. To achieve this, they try to predict consumer behavior. Producers ask themselves questions such as, «Will raising ticket prices by $1 drive away moviegoers, or will most consumers be willing to pay that much more?»

Producers use marginal analysis all the time. When producers can increase the utility of consumers, they sell more goods and services. When they can get the most out of consumers, they will maximize profits.

Producers study consumers to see how they make decisions.

More Than Price

Marginal analysis can be applied to other questions as well. Any time one more unit of something can be added, the question of whether it is beneficial to do this must be asked and answered.

A bank manager looks a bit worried. Her customers seem to be waiting a bit too long before they are served by a teller. What if she hired one more teller? The waiting time would decrease, and her customers would be more satisfied. If the customers do not have to wait very long, it is highly possible they will return to the same branch.

A hungry customer has already eaten three plates of sushi. He is considering ordering one more plate and uses marginal analysis to compare the pros and cons of doing so. He knows that he might not enjoy the fourth plate of sushi as much as he enjoyed the first three. And he does not want to get sick from overeating. In the end, his marginal analysis tells him to forgo that fourth plate.

David is a city council member. The council needs to vote on a one cent increase to a local tax. David and another city council member want to vote in favor of the tax increase. The extra money will allow the city to replace a worn-out playground at a neighborhood park, which would be beneficial to local residents with children. A third council member is against the tax increase, because not all residents will benefit from the new park, and she thinks the money could be spent in a better way. Marginal analysis is different from person to person because everyone has individual goals and values.

Everyone is unique. It is what makes people separate individuals, each with their own likes and dislikes. In the game of economics, this uniqueness means that consumers have different tastes and different preferences when it comes to buying goods and services. Look at all the brands and types of cereals in a grocery store. That should give you some idea of how diverse consumers’ tastes are.

Consumer decisions are influenced by many factors. Taste is just one of them. See the list below for some of the nonmonetary factors that influence consumers.

– Taste

– Culture

– Beliefs

– Values

Beyond Money

Culture, family traditions, and personal values all affect consumer decisions. These factors are nonmonetary incentives.

When a family celebrates Thanksgiving, they make economic decisions that might be influenced by the desire to cook the perfect meal. So, they might ignore other factors, like price, because they gain more utility from the feast itself than from cutting costs. The nonmonetary incentive of hosting a great Thanksgiving meal outweighs monetary incentives – at least to a point.

The combination of cultures, beliefs, and values leads to different kinds of decisions being made by different consumers, even when they face the same situation.

Working together as a family offers incentives that go beyond money.

Culture Matters

The desire for particular goods and services is often influenced by a person’s culture.

Part of the culture of the United States is Independence Day, or the Fourth of July. Thanksgiving is also important in the United States. Because of these features of the culture, consumers buy a lot of fireworks in early July and a lot of turkeys in late November.

How Culture Influences Consumerism

As we learned before, our economic decisions are based on what culture or cultures we belong to. Culture is more than just holidays and sports, though. For instance, the rock-and-roll culture is highly present in many countries around the world. People who belong to this culture enjoy dressing like rockers, buying and listening to rock music, attending concerts given by their favorite bands, and collecting memorabilia.

Traditional Native American cultures consider humans an integral part of the environment, not a dominating force. They are closely tied to natural resources and events, and they value and respect nature. For example, they avoid over-consumption of water or lumber in order to protect lakes and forests. They also value self-sufficiency, and often produce their own goods and services through gathering, hunting, and fishing.

We do not necessarily have to be part of a culture to celebrate it. For example, St. Patrick’s Day is an important holiday in Ireland, but it is also widely celebrated all over the world. On March 17 of every year, people of all different cultures can be found wearing green and making merriment. Producers take advantage of the universal appeal of St. Patrick’s Day to market and sell specific products, such as green clothing, festive decorations, and even green food. In this case, St. Patrick’s Day has become an adopted culture for many.

Values and Beliefs

Culture is more than just holidays and traditions. Different cultures have different values and beliefs that influence their members’ behavior.

Values and beliefs are linked. If you value a clean environment, then recycling is likely to be a part of your value system. Your behavior is guided by that value. If you believe that free trade is the best kind of system, then you would not mind buying leather shoes from Brazil or a pair of jeans imported from Italy. If you believe in supporting local businesses, on the other hand, you might buy only locally grown fruits and vegetables.

Producers try to understand consumers’ values and beliefs when allocating resources, because values and beliefs affect the way consumers make economic decisions.

For example, recycling is an integral part of South Korean culture. The government makes sure that recycling bins are available across the country, and it employs officers who routinely check to make sure people put their refuse in the correct bin. Because this is an important value among South Koreans, producers there try to make eco-friendly products to increase the sense of utility among consumers.

How green are you?

Risk Aversion

Every economic decision a person makes contains some sort of risk. Some decisions are less risky than others. If a college student puts $5 in a savings account, there is little risk, but also very little reward. Her money is safe, but it will not grow fast. If, on the other hand, she uses the $5 to buy a lottery ticket, she is taking a big risk, with the possibility of a great reward. Most likely, she has lost the $5 forever. But there is a slight chance she will win millions.

Many people play the lottery. Many others do not. This is because everyone has a unique level. Some people will always choose the less risky option, even if the possible reward is small. Other people will go with something far riskier in the hope that they will get a big reward.

It is common for people to have a high level of risk aversion. Security is an important value to many people. But many people have low levels of risk aversion. These risk takers make very different decisions than people who prefer to play it safe.

Here is one example of risk aversion. Suppose you loaned a friend $300 last month. Today, he offers to pay it all back, or to invest it in his Internet company. You have a high level of risk aversion if you prefer that he pay you the $300 now. You are not sure how profitable his business will be, so to you it is not worth taking the risk. You have a low level of risk aversion if you decide to let the $300 ride and see if you end up with more in the long run.

There is no such thing as a safe bet.

Let us Talk About You

Cultures, values, beliefs, and risk aversion all play a part in the economic decisions that people make. People do not even have to be consciously aware of these factors. They just do what seems right. This does not mean these factors are not influential. It just means that many consumers are not conscious of their influence.

You can see the influence these factors have more clearly if you think about your own views. Do you know what your value and belief system is? Do you ever think twice about making an economic decision based on what you believe in?

The media has all sorts of messages for us. At times it can feel like a constant bombardment from the television, the phone, and the Internet, not to mention the radio, magazines, mail, billboards, and all the other ways that words and pictures are hurled at us. It is almost impossible to escape the media.

Think of the many advertisements for products and services you see in just one day. Could you even count them all? In addition, you get warnings, instructions, questions, information, and all kinds of other messages.

Communication is an important feature of human behavior, and the media’s primary focus is communicating one message or another to consumers.

Types of Media

Companies use the mass media to communicate information about their products and services to a large number of people. Producers are aware that consumers are the ultimate decision makers in the game of economics. Producers, however, also know that the mass media can be a powerful method of persuading consumers to buy their goods and services. Take a closer look at how this works.

Traditionally, news media is a subset of mass media with its own content and purpose. In recent years, however, the lines between general mass media and news have blurred.

Influencing Consumer Behavior

Television, magazines, and other media can be highly influential. Popular sitcoms create images of consumption that inform our own consumer behavior.

Consciously or not, some people adopt the styles, fashions, and even attitudes of their favorite TV characters. Some consumers make decisions based on their desire to look or live in a way that resembles the lifestyles they see on TV.

Magazines can have a big effect on consumer behavior, as well. Fashion magazines influence some women’s perception of beauty and influence the products they buy. Men’s magazines also influence how men see themselves. They have articles that include news, sports, men’s fashion, and even lists of the top outfits men should have in their closets.

Some people adopt the styles they see on their favorite shows.

Mass Media

Mass media has a big effect on how consumers view themselves.

Companies advertise their products and services in all forms of media. This is done indirectly through product placement and directly through advertising.

Advertising is the biggest method used by producers to influence consumer behavior.

There are many methods and techniques of advertising. You are probably familiar with most of them already. TV commercials, magazine ads, billboards, and even signs on the sides of buses all infiltrate our lives on a daily basis.

On the Internet, most Web pages contain advertising, often including pop-up screens and animations. You can get advertising delivered directly to your cell phone, too.

It pays to advertise.

Over the years, the sophistication of advertising techniques has advanced, as have breakthroughs in communication technology. Many people use the Internet every day and depend on it to get information. This makes the Internet an enticing vehicle for advertisers. Unlike radio, television, and print sources, the Internet is a nonlinear form of media, making it possible to advertise in various ways. Banner ads, pop-up windows, corporate Web pages, and bulk e-mails are some of the methods used.

Advertising Strategies

The main purpose of advertising is to get consumers to demand more goods and services. There are many ways to do this. One is to create a need for a product by emphasizing the connection between a product and a certain aspect of life.

For example, most people want to be clean. Soap and shampoo are needed to be clean, but is that all? If advertising can convince consumers that they also need deodorant and conditioner to feel clean, then more people will buy deodorant and conditioner.

Advertisers can also succeed at increasing demand by getting people to see luxuries as necessities. This is usually just a perception – you think you cannot live without something when, in fact, you probably can.

The Brand-Name Game

In our fast-paced world, producers know that consumers like to find what they need quickly and conveniently. Today, you can order a product online from anywhere in the world and have it delivered to your house in a matter of days.

This leads to a lot of competition among producers who want consumers to buy their stuff. This is another purpose of advertising – to get people to choose a specific product or service instead of the same thing provided by a competitor.

One method used by companies to get people to buy their products instead of someone else’s is branding. Branding gets people to recognize a particular company’s product and associate it with quality and popularity. Some brands can even succeed in becoming common names for the products they sell, such as Kleenex or Band-Aids.

Branding is not the only method that advertisers use. Advertisers know that consumers are more likely to buy products that they identify with, so they make ads that appeal to people by telling a story or connecting the consumer to the product.

Some brands are so familiar that we use their names generically.

Adverse Advertising

People get their news mostly from TV, newspapers, the Internet, and the radio. When it comes to informing the public on goods and services, the news media can be an effective and powerful tool of communication. When a new product comes out, like the latest car, gadget, or toy, the news media will likely discuss it, providing another form of free advertising.

News stories also alert the public to defects, dangers, and recalls. This kind of negative exposure also influences consumers by getting them to avoid certain goods and services and to beware of dangers in general.

Producers Influencing Consumers

Consumers make the final choice in all purchases, but producers do not want to leave all of the deciding up to consumers. They want consumers to demand more goods and services, and they want consumers to choose their products over those offered by someone else. Producers try to influence what consumers think and do to increase demand for their products so they can beat out the competition.

Consumers are the driving force of the economy, but they cannot do it alone. Without producers, there would not be anything to consume. To have consumption, there needs to be production. That is why businesses are important.

Businesses come in all shapes and sizes, from small home businesses run by one person to large international corporations that employ thousands of people in dozens of countries.

In many ways, businesses are like consumers. But there are important differences too. You will study some of these key differences and learn more about the role of businesses in the economic system.

Producers make all kinds of economic decisions. Just like consumers, they use rational choice when they do. In fact, producers are often more likely than consumers to pay close attention to the rationality of their decisions.

Usually, there is a lot more risk for producers when it comes to decisions. As a result, producers have significant incentive to use cost-benefit analysis and other tools of financial management. If they do not make good decisions, they will not make money. If they do not make money, they will go out of business.

Producers try to be as rational as possible, so they can keep playing their role in the economy.

Producers and Rational Choice

Remember that rational choice is a decision-making process that compares the benefits and costs of an action. Rational choice is a way of looking at several potential choices and deciding which choice is the best.

You have seen how consumers do this. Producers do the same thing, though there are some important differences. For one thing, businesses consider benefits and costs just as a consumer does, but only the monetary costs and benefits are relevant to their calculations. Consumers often take into account non-monetary things when doing cost-benefit analysis.

For instance, a farmer decides which crops to grow just like a consumer decides what to eat for dinner. But while the consumer might consider nonmonetary factors, the farmer is going to focus on monetary considerations.

Consumers might think about what is cost-effective when planning dinner, but they probably also prioritize nonmonetary considerations, such as what they like to eat or how healthy the food is.

Farmers do not think about what they like to eat when deciding which crops to grow. A farmer’s food preference does not affect production decisions. What farmers do pay attention to is how much money it will cost to plant various crops and how much they can expect to earn by selling those crops. Whichever crop will have the highest expected return is the crop the farmer will plant. It is the rational choice in monetary terms.

Profit

Monetary calculations are central to any producer’s decision-making process because making money is the reason businesses exist in the first place. In a market economy, businesses are free to make as much money as they can.

To make a profit, a business must have more revenue than costs. This means a business must earn more from the sale of its goods and services than it spends producing those goods and services. Here’s a simple formula that shows how to calculate profit:

Revenue – Costs = Profit

Profit is often called «the bottom line» because it is at the bottom of the calculation. The calculation of profit can be a bit more involved than simply subtracting costs from revenue. There are different types of expenses – production costs, administrative costs, taxes, and so on – that are calculated and subtracted in different ways.

For example, imagine a lemonade stand that rings up $30 in sales on a particularly hot day. Making and distributing the lemonade cost $7. You can calculate profits with a simple equation:

$30 (revenue) – $7 (costs) = $23 (profit)

The lemonade stand made $23 profit.

The Profit Motive

Making profit is not just something businesses like to do. It is something they have to do.

Every producer must make a profit in order to remain in business. Without profits, businesses disappear. This gives producers the profit motive, which tells them that they have to minimize costs and maximize monetary benefits. This is not exactly a law of economics, but it is so universally followed that it might as well be.

The profit motive is a necessity. Producers who choose to ignore profit end up going out of business. Only those businesses that have the profit motive will remain in business. You can easily say that all businesses are driven by the profit motive because they do not have any other choice.

Profits and Losses

A free-market economy is driven by businesses’ desire to make a profit. Businesses make production, pricing, and hiring decisions based on that goal. A business that keeps costs low and brings in more money than it spends makes a profit.

If costs and revenues are equal, the business is just breaking even. And when costs are higher than revenue the business is running at a loss. A business can break even or run at a loss for only so long before going out of business.

Even when a company is making a profit, the profit motive is an incentive. Because of competition, there can be pressure to make greater profits the next year. When other companies are increasing their profits, a business can fall behind even if its revenues are above its costs.