Monday, July 16, 2007

Economics of Saving Money

What can economics tell us about frugality and saving money? We can use certain Economic concepts to evaluate how and why we should make certain savings and not others.

Opportunity Cost

Opportunity cost is the concept that each decision has a next best alternative. If you spend £1000 on repairing your car, it means you can't put that money towards buying a new car. If the car is on its last legs, you'd be better off biting the bullet and spending £3000 on a new car rather than keep patching it up. If you spend 10 hours filing your tax return, it means that you lose 10 hours which you could have spent working. Therefore, when we seek to save money, we need to make sure it is worth it. For example, there is no point in saving £1 on parking if it means that we need to spend 30 minutes extra walking. In this case it would be better to pay the £1 and gain time.

Diminishing Returns.

Why are diamonds more expensive than water when water is much more useful and essential to life? It is to do with diminishing returns. The first diamond in our life gives a very high utility (satisfaction) therefore, we are willing to pay a high price for this once in a lifetime purchase. However, if we purchase more diamonds, the utility we get quickly falls. If we had 10 diamonds, what would we do with them? They are surplus to requirements. However, with water, we need to drink it throughout life.

Be careful about purchasing too many goods which give us diminishing returns. If we get joy from eating chocolate, it doesn't mean that we should buy as much as possible. Be aware of when diminishing utility from different goods sets in.

Efficiency.

Efficiency is concerned with the optimal production and distribution of resources. The first type of efficiency is to reduce costs, such as, reducing the running cost of running your house. Look at labour saving technology to improve efficiency in the long term. Efficiency is also concerned with the optimal distribution of your scarce resources. Take time to make sure the price of a good is less than the marginal benefit (satisfaction) that you get from it.

Economies of Scale.

Economies of scale assumes that the more you produce of something the more efficient it becomes. This can be applied to various aspects of life. For example, purchasing economies means when we buy in bulk we get discounts and a lower average price. With regard to earning money, economies of scale suggest it is better to specialise in certain fields, rather than be a jack of all trades and master of none.

Monopoly.

A monopoly can exploit the customer by charging higher prices. Look to see whether firms have monopoly power over yourself. If you still get energy supplies from the established company, you are probably paying a premium. Look to switch to one of the competitors. Firms are cunning in creating monopoly power. One way then can charge higher prices, is through exploiting consumer inertia. Because people are too lazy to move accounts, firms can charge higher mortgage and insurance quotes to their existing customer. Each time you renew insurance quotes, make sure you are in the competitive market and not giving your existing firm monopoly power.

1 comment:

Best Savings Account said...

Great tips! because we don't know the future and having some money saved gives us security and safety. Thanks