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There are four principles that Gregory Mankiw outlines in his multi-disciplinary economics textbook Principles of Economics. I got the idea for reading an Economics textbook from Charlie Munger, the billionaire business partner of Warren Buffett. He said:
So we know that we can add Opportunity cost and incentives to our list of Mental Models. Let’s dig in. Principle 1: People Face Trade-offsYou have likely heard the old saying, “There is no such thing as a free lunch.” There is much to this old adage and it’s one we often forget when making decisions. To get more of something we like we almost always have to give up something else we like. A good heuristic in life is that if someone offers you something for nothing, turn it down.
These are rather simple examples but Mankiw offers some more complicated ones. Consider the trade-off that society faces between efficiency and equality.
Principle 2: The Cost of Something Is What You Give Up to Get ItBecause of trade-offs, people face decisions between the costs and benefits of one course of action and the cost and benefits of another course. But costs are not as obvious as they might first appear — we need to apply some second-order thinking:
Principle 3: Rational People Think at the MarginFor the sake of simplicity economists normally assume that people are rational. While this causes many problems, there is an undercurrent of truth to the fact that people systematically and purposefully “do the best they can to achieve their objectives, given opportunities.” There are two parts to rationality. The first is that your understanding of the world is correct. Second you maximize the use of your resources toward your goals.
Thinking at the margin works for business decisions.
This also helps answer the question of why diamonds are so expensive and water is so cheap.
Incentives induce people to act. If you use a rational approach to decision making that involves trade offs and comparing costs and benefits, you respond to incentives. Charlie Munger once said: “Never, ever, think about something else when you should be thinking about the power of incentives.”
Failing to consider how policies and decisions affect incentives often results in unforeseen results. |