collage of money, charts, student working and graduating

A Little Economics Goes a Long Way

Antoine Cournot was a 19th Century French economist, mathematician, and philosopher.  He is widely known for his theory of monopoly and duopoly but I like him because of his mathematical proof known as Cournot Aggregation.  Cournot aggregation, mathematically, is written as follows; Wxxx,x + Wyxy,x = -Wx [i].  (For those of you better versed in English, as opposed to Greek formula, you may want to skip the endnote that explains the formula.)  In plain English, it is like my high school friend Monty would have said, “If the price of suits goes up, I don’t care.  I don’t wear suits.  But if gasoline for my ’57 Chevy goes up, I’m in a world of hurt, as that 327, V-8 engine purrs on premium gas!”  Monty probably didn’t get more than 8 miles to the gallon and he drove a lot of miles. On the other hand, if the price of gasoline fell to half of what it was, Monty would have had enough money to take his girl to the drive-in movie[ii].

The following is a table of the rate of price change for broad categories of goods that we purchase (for more information: Bureau of Labor Statistics).  The second column is the percentage change in prices between March 2008 and March 2009, the third column is the percentage change in prices between March 2009 and March of this year, while the fourth column is the combined rate of inflation over the period 2008-2010.  I have taken the liberty to highlight double-digit increases in prices in blue and any decrease in prices in red.  As you can see, the change in prices is not uniform across categories.  Take, for example, prices from 2008 to 2009, across all goods, fell by 0.4%.  Yet, for most categories of goods, prices actually went up but these increases were outweighed by the decreases in prices for transportation and fuel during the 2008-2009 time period.

Category of Expenditure

Rate of Change March 2008 – March 2009

Rate of Change March 2009 – March 2010

Rate of Change March 2008 – March 2010

All Goods

-0.4%

2.3%

1.89%

Food and Beverages

4.3%

0.3%

4.61%

Food

4.4%

0.2%

4.61%

Food at Home

4.3%

-0.7%

3.57%

Food away from Home

4.6%

1.2%

5.86%

Alcoholic Beverages

3.6%

1.1%

4.74%

Housing

1.4%

-0.6%

0.79%

Fuels and Utilities

0.6%

0.9%

1.51%

Household furnishings

1.8%

-2.3%

-0.54%

Apparel

1.4%

-0.4%

0.99%

Transportation

-13.1%

13.3%

-1.54%

Private Transportation

-13.6%

13.8%

-1.68%

Motor Fuel

-39.6%

41.1%

-14.78%

Public Transportation

-5.0%

6.1%

0.79%

Medical Care

2.8%

3.7%

6.60%

Recreation

1.7%

-1.1%

0.58%

Sporting Goods

3.2%

-1.2%

1.96%

Other Recreation Goods

-3.5%

-3.1%

-6.49%

Recreation Services

2.4%

-1.2%

1.17%

Education

5.6%

4.9%

10.77%

College Tuition

5.8%

6.0%

12.15%

Communication

1.7%

0.0%

1.70%

Other Goods & Services

5.7%

4.9%

10.88%

Tobacco

18.1%

15.9%

36.88%

Personal Care

2.1%

1.2%

3.33%

Now, look at what happened to fuel prices and transportation between 2009 and 2010.  You will note that while prices for fuel fell from March 2008 to 2009, to 60.4% of their March 2008 price, their price rose to 85.2% of the March 2008 price, by March 2010.  (Here’s the math: If something cost a $1 in 2008, it would fall to $0.604 in 2009, with a 39.6% decrease.  Then, if the $0.604 price increases by 41.1%, you would have $0.852.  Still, this price is below $1, but that bloke that purchased the Hummer in March of 2009, sure thinks that gasoline is more expensive!)

Look back at the Financial Tip from the last week of January 2010: Are You Middle Class?.  In it you will see the proportion of the average household budget spent on various categories of goods.  The table tells us that housing takes up the largest proportion of the average budget.  Thus, when the price of housing decreases, assuming you don’t own the now low-priced home, the total effect on you is an increase in consumption of other goods, including savings.  On the other hand, if you are working part-time while you are going to school and much of your income purchases college tuition, you notice the decrease in your consumption of everything else, as college tuition rose, on average, by 12.15% over the past two years.

You might be wondering, “How is this a financial tip for financial success?”  The lesson is simple, yet not widely practiced.  First, be modest in your expenditures and keep them at a reasonable level, relative to your income.  If the average budget share for your income category is 20% of expenditures, try to keep yours below 20%.  If you do this for all categories of expenditures, save 10% of your income, and have an adequate reserves to provide liquidity in the case of an emergency, you are a financial success.  Moreover, you didn’t have to learn Greek, nor spend like them, to get there.

ps:  For ideas on how to save money, check out this link: 66 Ways to Save Money.


[i] The mathematical “bottom-line” states that a percentage change in the price of a good x will have a resulting percentage change in the consumption of good x (xx,x, own price elasticity of demand) and all other goods y (xy,x, cross-price elasticity of demand) that, when weighted by their respective budget shares (W), is equal to the negative of the share of the consumer’s budget that is spent on good x (-Wx).  Thus, changes in prices have a greater effect, the greater the proportion of your budget you spend on the good with the price change.

[ii] I know that many of our student readers have never seen a drive-in movie, nor do they have the foggiest idea what is so special about a ’57 Chevy.  Take it from me, however, that magic would follow when a ’57 Chevy was paired with a date to a drive-in movie, during the 1960’s.