Mental Model Lollapalooza: Principles of Economics
The Building Blocks of Rational Decision-Making
Mental Model Lollapalooza
Charlie Munger is the business partner of Warren Buffett and one of the most successful investors of all-time. He is a huge believer in gathering a ‘latticework’ of elementary mental models from a variety of disciplines in order to improve your decision-making in business, academic research, and virtually all aspects of life. Through this series, the Mental Model Lollapalooza, we will explore around 100 mental models (the number Munger himself uses) to arm us with a multi-disciplinary toolkit to understand the world around us.
Click here for a link to the main Mental Model Lollapalooza article.
Principles of Economics
Greg Mankiw is a Professor of Economics at Harvard University. He is arguably the most successful economics professor ever:
- According to the Open Syllabus Project, Mankiw is the most frequently cited author on college syllabi for economics courses.
- In 1995 he “was offered a $1.4 million advance… to write a basic economics textbook. That’s about three times as big as any other in the college textbook market and rivals those of all but a few celebrity authors.” This book, Principles of Economics, has since gone on to generate around $42 million of royalties for Mankiw.
It is this book, Principles of Economics, that this article stems from. In the first chapter, Mankiw outlines the ten principles that form the central ideas for economics.
Understanding these principles, and building them into our repertoire of mental models, will put us in a better position to make decisions and to understand the factors affecting the decision-making processes of other people. We will examine each of these principles below.
Finally, we will explore some of the assumptions made about human beings in classical economics and why that leads Charlie Munger to use a ‘two-track analysis framework’ when making decisions.
The principles that Mankiw outlines are broken into three major themes that explain the different levels of scale at which humans make decisions.
- Individual decision-making: these principles explain how people make decisions on a rational basis on an individual level.
- Interactions between people: these explain the types of decisions made between multiple people.
- Economies as a whole: these explain the governing principles that guide decisions affecting the entire economy.
When discussing decisions impacting the entire economy, it can be hard for people to remain objective and disassociated from any particular political ideology. Despite the objectivity of his work, Mankiw experienced a walkout in 2011 when dozens of students from his economics class protested that Mankiw was giving them an incomplete picture of economics resulting in ‘problematic and inefficient systems of economic inequality in our society’.
To be clear, these principles explain the types of decisions that people, companies, and governments have to make. They do not make suggestions for the specific policies that people should adopt.
Individual decision-making
Scarcity
People need to make trade-off decisions based on the fact that most resources are limited, including money and time.
Let’s consider a man, Ed, whose dream is to build his own large house in the quiet countryside. He’s been working as an economist in New York for a number of years and has managed to save up $1 million.
Clearly, Ed will be able to build a very nice house in a rural area for that much money. However, despite how rich he may feel with his $1 million, Ed’s not infinitely rich. He might be able to build a three-story, five-bedroom house with a decent home gym. He may even have enough money left over for a pool. If he wants to also add a standalone two-car garage, professionally landscaped garden, and a spa, he’s probably going to run out of money before he gets through that list.
His resources, in this case, his money, are scarce, and as a result, he needs to make a trade-off between his options.
How should he decide between the uses for his money?
Opportunity cost
When making trade-off decisions due to scarce resources, it’s not always obvious what the full cost of our decision is.
When deciding whether we want to buy a new book that helps us understand the science behind cooking great food (I recommend Salt, Fat, Acid, Heat) the initial cost is clear: $35.
However, to understand the full cost, we need to take into account opportunity costs.
- The first opportunity cost is the choice we’d be making to spend some of our money on a book, and not on going out for dinner, or perhaps putting the money in a savings account. We might consider ourselves very wealthy and think the cost of $35 is negligible, in which case the enjoyment we may get from the book may be worth a lot more to us than having the $35 in our bank account. But if we picture a $2000 holiday instead, it should be obvious that the opportunity cost of spending money on one thing instead of putting it to another use is very real indeed.
- The second opportunity cost in this situation is the time we will spend reading the book. Let’s say it’ll take us roughly 5 hours to read our new book. We could be spending that time on another hobby, working extra hours, exercising, or even reading another book. Time is arguably our most scarce resource, so this cost is also very real!
- Opportunity costs also often have consequences reaching into the future. Had we read Salt, Fat, Acid, Heat, we may be able to enjoy much better home-cooked meals than we have been eating previously. As a result, between a book of the same price that we’d enjoy slightly more in the short-term, the correct choice for us may be to invest the time in this book to enhance our cooking ability and reap the rewards for a long time to come.
Because life is so complex, the full opportunity costs of a situation can usually never be known.
Had we read the cooking book, we may have discovered a passion for cooking we never knew we had and go on to become a Michelin Star Chef. Maybe if we’d taken our friend up on their offer for a meal out instead of spending the evening reading our book, we could have met the love of our life.
The best we can do is to take time to understand the different opportunity costs at play to minimise the risk that we’re missing a major one. Just being aware of the concept of opportunity costs is a major step in the right direction to making more rational decisions.
For Ed and his house, when deciding whether to build his garage we can now see the opportunity costs at work- he may have to forego a pool to have the funds for the garage. The pool may bring him more happiness and well-being, but not having a garage may result in his car insurance premiums being increased.
Marginal returns
Let’s suppose that Ed gets his house built under budget, spending $750,000 of his $1 million. Soon after, he realises that he hates the countryside, and more than anything in the world he just wants to go back to New York. He puts the house on the market and there are plenty of interested buyers.
Unfortunately, a tree caves in part of his roof and causes $250,000 of damage just before a sale goes through. The buyer pulls out and Ed realises nobody’s going to buy a house with a big hole in it. He’s still determined to sell it and gets advice from a real estate agent who tells him if he invests his last $250,000 to fix the house, he could sell it for $500,000. Without fixing the roof, the agent will buy it from Ed for $100,000. If he takes the offer, it would mean he’s invested $1 million into the house overall and only earned $500,000. What should Ed do?
If he’s rational- Ed will consider the marginal cost of $250,000 and the marginal return of $400,000 ($500,000 if he fixes it minus the $100,000 he could get without fixing it) and come to the conclusion that it’s a great deal. Even though he’s still losing $500,000 overall, he should make a decision that improves his current position by considering the marginal gain.
Airlines have a very simple example of marginal returns. Let’s say it costs an airline $500 per seat of a 100 seat plane to make a flight. They charge $600 per seat to ensure they make a profit. 30 minutes before the flight, they’ve sold 90 of the seats at $600. Someone at the airport offers them $250 to take a seat on the plane. Should they accept the offer? Yes! Even though they have to make $500 per seat to break even, the marginal cost of letting that passenger on is virtually zero since the seat is empty, and the $250 they make from his ticket is almost entirely profit.
Incentives
The final principle of economics concerning individual decision-making is that people make decisions based on their incentives.
The idea that people make decisions based on their incentives sounds obvious, but not taking people’s incentives into account can lead to terrible policy decisions, whereas shaping a system to align someone’s incentives with a desired goal can drastically increase the chances that the goal is achieved, such as paying commission to salespeople to increase sales.
Considering the full impact of incentives often leads to surprising results. Sticking with the home selling theme, here’s an example from Wikipedia’s perverse incentives article:
Real estate brokers have an inherent conflict of interest with sellers they represent because their usual commission structures motivate them to sell quickly rather than at a higher price. However, a broker representing a buyer has a distinct disincentive to negotiate a lower price on behalf of their client, because they will simultaneously be negotiating their own commission lower
In Freakonomics (Amazon affiliate link), the author explains how real estate agents tend to sell their own houses for more money than their clients’ houses. As explained above in the Wikipedia excerpt, when a real estate agent is only receiving a commission of a small percentage of the overall selling price, it’s often more profitable for them to sell at a lower price than spend time negotiating the price higher. Conversely, when selling their own house, a real estate agent would gain the full increase in the selling price, so they’d be incentivised to spend more time on the negotiation.
Interactions
Mutual benefits of trade
Sony (PlayStation) and Microsoft (Xbox) both compete for gaming customers, Airbus and Boeing both compete to sell their airplanes. Countries such as China and the US are often also described as competing with each other.
On a smaller scale, we often think of the job market as a competition whereby multiple people are competing for available positions. Similarly, people also compete when it comes to shopping as they want to buy the best goods at the lowest prices. Despite this competition, it would clearly not be better for people to remove themselves from society and fend for themselves.
Without trade, each family would need to build its own house, grow its own food and treat its own members when they get sick.
Trade can be mutually beneficial as it allows people to specialise in certain areas and therefore to produce more goods and services than they’d be able to without specialising.
There are political considerations to be made regarding trade deficits or outsourcing farming to other countries, but the principle that trade can be mutually is generally true.
The benefits of markets
One of the biggest economic challenges in the 20th century was the struggle between Capitalism and Communism. Capitalists believe that creating markets for goods and services, where prices are set by the forces of supply and demand, is a superior system to a centrally-planned economy, where prices are set by a government official.
The main problem with central planning is that the economy is far too complex for any person, or group of people, to make decisions such as how much certain goods should be sold for.
In a market system, prices are set and resources are allocated by what Adam Smith dubbed the invisible hand.
The invisible hand works as follows: people bid up the price of goods. As the price increases, demand declines as some people won’t be willing to pay the increased price. Some companies, seeing the higher profit margins available in selling this product will enter the marketplace (unless there are barriers to entry- these are covered in my article on Competitive Advantages). As the supply for the product increases (due to more companies entering the market), they compete with each other on price. As the price is lowered, the demand once again increases.
This principle of supply and demand theoretically reaches an equilibrium, where supply and demand are equal and prices stabilise. However, it has been shown by some ambassadors of a sub-field of economics often called Complexity Economics, and in particular by Brian Arthur, that this equilibrium is only reached in simplified economic models, not in the real world, due to the complexity of the real economy and the imperfect decision-making ability of humans.
Government involvement
As we saw in the fourth principle of economics, people make decisions based on their incentives. Through the forces of supply and demand, markets adjust people’s incentives. Suppose that in a world with free markets but no government, there was suddenly an increase in demand for a specific type of classic car. If the price is high enough, the incentive to steal that car to sell on becomes very high. Similarly, a farmer would not choose to farm his land or raise cows if he suspects these will be stolen. Governments, by altering people’s incentives (through fines or prison sentences), can help individuals within an economy build trust, enabling more trade, which as we saw can be mutually beneficial for all members of that society.
One of the key problems with markets is externalities. Suppose you’re a smoker; you’ve made the decision that the enjoyment you get from smoking is worth the risks, but if smoking is allowed in public buildings or workplaces, the smoke can harm many other people who had no say in your decision. Similarly, a company may choose to pollute the environment by using particularly environmentally-unfriendly manufacturing practices in exchange for a higher profit margin. The government can help protect the individuals who are external to the decision-maker by fining people who smoke indoors and by offering subsidies for greener methods of manufacturing, or introducing pollution taxes.
In addition, a government may step in to regulate, or outright ban certain markets. It may be genuinely tempting to some people to sell one of their organs, such as a kidney, to improve their financial position. The government can ban such a market to attempt to prevent such transactions from being made.
In a less extreme example, suppose there is only one water source for a town, and a single utility company owned this source and the necessary pipes to distribute that water to the citizens. As the demand for water will always be high, but now the supply is controlled by a single company, without the government regulating this market in some way, the company could set water prices as high as they wanted and people would be forced to pay them (or move to another town).
Economies
Standard of living
Prior to Adam Smith, people generally believed that a country’s wealth was linked to how much gold they possessed. Adam Smith showed that in fact the wealth of a nation was in the value of the total amount of goods and services its economy produced.
I find this example to be more obvious when thinking about companies instead.
Take Alphabet, the parent company of Google; they have $201 billion worth of equity (all their assets minus their liabilities), but the company at the time of writing is valued at $1.3 trillion. This is because, as with countries, the value of a company is not what assets it has but the value it produces through the goods it creates and services it undertakes.
Too much money printing equals inflation
Inflation is the technical term for prices increasing. In 2018, inflation was 1.8% in the US, meaning that on average, something which cost $100 at the start of the year would cost $101.8 at the end of the year. In Venezuela for the same period inflation was 130,060%, meaning something that cost 100 Venezuelan bolivares at the start of the year would cost 130,160 bolivares by the year’s end.
High levels of inflation, and in particular hyperinflation (when prices increase by more than 50% per month) are damaging to the economy: they can cause political instability, people begin to hoard goods such as food, which can lead to food shortages, and people’s savings can become worthless.
Due to the harm caused by high inflation, a common economic policy worldwide is to keep inflation at a low level. How, then, does high inflation arise?
The primary cause of high inflation is governments increasing the money supply. According to Mankiw’s Economics:
In almost all cases of high or persistent inflation, the culprit turns out to be the same — growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money falls.
Inflation Vs Unemployment
In the short-term, society faces a trade-off decision between inflation and unemployment.
When more money is printed, inflation increases, but unemployment tends to decrease as the extra money present in the society either directly or indirectly leads to more jobs.
This is still somewhat controversial, and there is much debate about the long-term impacts of this trade-off, but it is generally accepted that in the short-term, policies that lead to higher inflation (such as reducing taxes or increasing stimulus) tend to lead to lower unemployment, and vice versa. This relationship is known as the Phillips curve.
Two-track Analysis
As is outlined in the first four principles of classical economics, rational people make decisions by analysing the opportunity costs of the trade-offs those decisions result in. Their opportunity costs are influenced by their incentives.
The key issue here is the assumption of rationality. It’s fair to assume that humans are at least somewhat rational: people generally do things that are in their own interest. However, we do not have infinite computational powers to make decisions, nor would we really want to use all the powers we do have for small decisions.
Enter, bounded rationality. This concept was coined by Herbert Simon, during his work on economics that earned him a Nobel Prize in 1978, to tackle the clearly unrealistic assumption that human beings are infinitely rational.
Bounded rationality is the idea that when making decisions, individuals are limited in their rationality by their own cognitive abilities, the time available to make the decision, and the difficulty of the problem.
Simon addressed this problem by seeking to understand how people really behave in circumstances where an optimal solution can’t be identified. His theory is that, in such situations, people act as satisficers: they search through the available alternatives until an acceptability threshold is met.
People can satisfice in one of two ways: “by finding optimum solutions for a simplified world, or by finding satisfactory solutions for a more realistic world. Neither approach, in general, dominates the other, and both have continued to co-exist in the world of management science".
How does Charlie Munger think about this in his decision-making?
Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often misfunction.
By understanding both what rational people would do in a given situation and the mental biases that impact human decision-making, Munger is able to build a much clearer picture of the possible eventualities in a given situation- something that is of enormous value in a field such as investing or business strategy but is clearly of value in almost all areas of decision-making.
Summary
Understanding the ten principles of economics can help you make better rational decisions and helps to provide context around the policy decisions being made across the globe.
However, these principles are only the building blocks of economics as a field of study. To be more fluent in the field, studying Mankiw’s Principles of Economics (Amazon affiliate link for Americans), or Economics (Amazon affiliate link for the global audience), will explain how these principles combine and interact in the real economy.
Further, classical economics makes assumptions about human rationality that simply aren’t true. To get a true sense of why policymakers and individuals make the decisions they do, an understanding of behavioural economics is also required.
Being fluent in both of these areas, classical and behavioural economics, enables a Charlie Munger-esque two-track analysis.
Mental Model Lollapalooza Catalogue
Thanks for reading this far! If you enjoyed this article, be sure to check out the catalogue of other mental model articles (click here for the link) to further broaden your multidisciplinary mindset.
