Economists Understand The Science Of Money – These Are 5 Mental Models To Help You Think Like An Economist
Economists operate according to an organised, methodical and mathematic method. These are 5 Mental Models to help you think like an economist that they would use as well.
There are 100’s of principles and Mental Models that dominate the thinking of economics. Someone who makes fun and draws scepticism of this thinking is brilliant Nassim Taleb.
Here are the 5 Mental Models that help you think like an economist.
Pareto Principle
Otherwise known as the 80/20 rule. This quasi natural law and rule of distribution in competitive domains packs a hefty and powerful insight.
With +/- %5 variability, the Pareto Principle can be applied to both natural phenomena and human activities.
The man who coined the concept, Vilfredo Pareto, noticed that In 1800s Italy 80% of the land was owned by 20% of the population. It then turned out, that an 80/20 distribution doesn’t stop there.
In todays world…
- 80% of the wealth is held by 20% of the people.
- 80% of the crimes are committed by 20% of the criminals.
- 80% of the alcohol is drunk by 20% of the people.
- 80% of the value is achieved by 20% of the effort.
- 80% of software customers use only 20% of the softwares features.
- 80% of your sales come from 20% of your salesmen.
- 80% of the peas are harvested by 20% of the pods
- 80% of the worlds food grows in 20% of the countries.
- 80% of you will only read 20% of this article.
As you can see, the Pareto Principle infers that across almost any feasible domain, 80% of the value is determined by 20% of the inputs.
Opportunity Cost
Opportunity Cost is a powerful economic concept. It measures the value of any alternative to an action.
Think of Opportunity Cost along the lines of ‘FOMO’ (Fear Of Missing Out).
It is a major factor for pricing in the true value of an action you may take. Whatever alternative potential you forgo in order to take a certain action is measured as the opportunity cost.
Imagine you have the decision to make between going to the bar with your mates for dinner, or staying home and looking after your two children.
The opportunity cost of you going to the bar is the value of the alternative.
One night less with your children and the cost of a babysitter.
The opportunity cost of staying home with the children is the value of the alternative.
The cost of the pub, and a good time with your mates, which are rarer and rarer these days.
Utility
Utility is a powerful mental models to help you think like an economist. It is a measure of somethings value or worth, typically independent of numerical foundation.
How can you ascribe value to something abstract?
If I am trying to determine how much value I get out of eating a piece of chocolate, I might say the my utility for one chocolate is higher than another.
Utility is an important measurement for determining Opportunity Cost and also for understanding the price of ‘externalities’ that may not be numerically accounted for.
The Law Of Diminishing Returns
In anything from which you yield value, there is a point where the next additional input will actually have no or negative impact on the overall output. It is the step after an additional input yields addition marginal return when this flatlines or turns negative – you have reached diminishing returns.
This law is most readily applicable to supply chains and businesses. But I will use the example to explain a social phenomenon.
I hypothesise that thousands of Tinder users across the world have actually hit Diminishing Returns in their relationship with the app. When your time spent swiping and chatting becomes more tiresome and meeting the men/women becomes unsatisfying, you have hit Diminishing Returns.
At this stage, each additional swipe and message actually detracts from your overall output from the app.
Compounding
Supposedly, Einstein called compounding the eighth wonder of the world.
The power is outrageous. Compounding is significant because of its exponential properties.
Compounding occurs outside of money markets as well. The most wonderful effects of compounding influence ideas and relationships.
Simply, compounding money in a bank account refers to interest on previous gains from interest plus your initial capital iterating again and again for eternity.
When ’Fry’ from Futurama put $5 in his bank in the year 2,000. He managed to withdraw $1,000,000,000 in the year 3,000. This was because of the magic of compounding.
A classic one. How many times do you need to fold a piece of paper for it to reach the moon? 45 times. Unbelievable.
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