to use rational choice before we make a decision.
When consumers make a purchase, they try to make rational, or wise, decisions. Often, economic decisions are made after thinking about price, quantity, need, and sacrifice. But sometimes economic decisions are irrational, or unwise. Irrational economic decisions can lead to trouble.
Cost-Benefit Analysis
To make rational choices, we need lots of information. In fact, making wise decisions usually involves cost-benefit analysis. A rational choice will seek to maximize benefits while minimizing costs. Costs and benefits differ from one consumer to the next, so each person’s rational choice will be different as well.
It is Your Call
Think, for example, of trying to make a wise decision about which cell provider to use. One company offers 5,000 minutes for $50. Another gives 2,000 minutes for $45. The extra benefit is 3,000 more minutes for a cost of only $5. It seems like a good deal, right? If you regularly use 3,000 minutes per month, it is a good deal. But what if you never use more than 1,500 minutes per month? There is no need to pay for extra minutes if you will never use them.
By using information about the two plans and your own needs, you would be able to make a cost-benefit analysis and come up with a rational decision.
Financial Planning
Cost-benefit analysis is helpful when it comes to making decisions, but it is not the only tool used by consumers. Consuming usually involves money, and most of us need to plan ahead and keep track of our money to make sure there is enough when we need it. This involves financial planning, which is the creation of a strategy to pay for necessities and save for future goals.
Give Me a Break
Imagine that you have saved some money and now you are ready to choose how to spend it. Some of your friends are planning to go to the beach on the weekend. You would like to join them, but if you spend your money on a day at the beach, you will not have any left. Do you need or want that money for something else? A financial plan can help you answer the second question.
As with rational choice, financial planning requires information and an understanding of your financial goals. Financial planning is another form of rational choice. You decide whether the benefits of a purchase now are worth the cost of not having the money for a different purchase later.
The Benefits of a Budget
One tool that some consumers use to help with financial planning is a budget. A budget allows a person to control how much money is coming in and how much is going out.
The main idea behind a budget is to have enough money to pay for the thing you want and need. A consumer with a budget knows whether he or she can afford to go on a beach vacation without spending money needed for rent or bills. A budget can also help consumers reach their financial goals. A budget can help you save for the future by keeping your expenses below your income. This leads to savings now for spending later.
Top Five Benefits of a Personal Budget
Know how much money you are making.
Know how much money you are spending.
Know how much money you are saving.
Plan for future expenses.
Plan for future savings.
Fixed and Flexible Expenses
Expenses are part of life. A budget helps monitor and control them.
There are two main types of expenses: fixed expenses and flexible expenses. Fixed expenses, such as rent, a car payment, or tuition, are necessary and generally do not change from month to month. Flexible expenses, such as buying video games, paying for car repairs, or purchasing new clothes, are non-necessary or unplanned spending. Sometimes, flexible expenses can be adjusted or eliminated. At other times, however, they cannot be avoided.
Fixed expenses must be taken into account in a budget, because they rarely change and usually cannot be eliminated. Once the fixed expenses are paid for, there may or may not be much left for flexible expenses.
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.
