How Understanding the Marginal Utility of Money Will Make you Happier

 

Money is a very interesting thing, and not as simple as it seems at first glance. I really didn’t understand it’s complexity until recently. We go to work and in return we receive money as payment.  We spend this money on stuff. This is as sophisticated as most people get. I thought of myself as intellectually fancy because I understood compound interest and investing, and other such complexities but it turns out I hadn’t even scratched the surface. What I didn’t understand is how the value of money changes with respect to utility and time depending on how you use it.

 

There is a paradox that I want to explore with you and it is this:

A dollar (or pound, euro, whatever) is the same whenever you earn it, whether it is the first dollar or the millionth. It has the same spending power, same value; it is an indistinguishable commodity. A dollar is a dollar. Early on in my life this was all I knew, and for most people this is as far as their understanding goes. There is more to it though.

 

Depending on when and what you spend the dollar on, the value is usually drastically different in the amount of additional comfort or happiness it brings, and, after all, the stuff we buy with money is just a means to this end goal of happiness. The millionth dollar does not bring as much happiness or utility as the first. In fact, at some level each additional dollar probably brings a small amount of unhappiness in the form of additional complexity, worry and dependence on the next dollar. This concept was popularized in the book Your Money or Your Life.

 

Using my sophisticated drafting and artistic skill set I’ve provided you with a series of graphs illustrating my point.*

 

 

In this first graph you can see that the more money you spend, the more happiness you obtain up to a point. This point will be different for everyone. The first dollars you spend bring you more happiness because presumably you are spending them on things that bring more utility and are more important to you. At some point additional spending has very little effect.

 

Money = Time

 

To expand this thought, money is really a representation of our time. Money is a store of value. We trade time and energy (our life energy) for money – with the expectation that we can trade it back to other people in the future for either stuff or their energy.

 

For most of us the relationship between time and money is more or less linear. After we obtain our training we trade X time and get Y money.  2X time = 2Y money. Not always, but often, and especially when we think of it in terms of years worked. For some people there is a little upward curve to the graph, or the slope changes with a promotion or new job title.

 

 

This is where I was in terms of my understanding of money a few years ago, after deciding to work on my early financial independence and freedom. What I didn’t appreciate until very recently was that although trading time for money is usually necessary for most of us, it ultimately is a trade that is not in our favor as we get older. The longer into life we make this trade, the worse the exchange rate gets for us.

 

Confused? Let me explain. It took me a while to wrap my head around this too.

 

Scarcity

 

Our time is limited. It is a blink. As time moves forward it becomes increasingly more valuable because we have less of it remaining. Each day we march closer towards our inevitable death. Time becomes scarcer, although without knowing the exact time of our death we don’t know with certainty the magnitude of how this function changes over time.

 

Each moment we move closer to our death, whenever that may be, so each second ticking by represents a greater fraction of the remaining life we have left. One minute before we die that minute is our entire remaining life. Assuming equal health and life satisfaction this means trading time for money is a better deal earlier in our lives when we have more of it. **

 

 

To summarize: Each additional dollar acquired becomes less valuable because it brings us a smaller bit of utility than the one before it. Each unit of time we trade for that depreciating money is more precious.

 

How much is your time worth when you’re on your death bed? How much money would you trade for a few more days? Would you work or spend it doing something else?

 

I know, it’s a little depressing, but hang on with me here for a moment.

 

The key to taking advantage of this trade and maximizing it is to understand the marginal utility of money. The average household income in the United States is around $50,000. The first $10,000 of that total brings much more happiness than the last $10,000. Without that first $10,000 you would be completely dependent on others for food and shelter. You would be very limited in the decisions you make. You would have a low amount of freedom.

 

Conversely if you shave $10,000 off the total and are now making $40,000, your life is still bearable, and maybe even downright awesome. You may need to live in a smaller apartment, drive a little less expensive car, not eat out at as fancy of restaurants, get rid of cable and use the library instead of buying books, etc. The point is, even though a dollar is a dollar, the first ones you spend tend to matter more in your life. When something is scarce we tend to trade it for things that bring us the greatest value first. Most of us are happier with enough food and a warm place to sleep than designer clothes and a gym membership. Without the former, the latter doesn’t matter as much.

 

The effects become much more pronounced at higher income levels. Happiness studies have shown more or less that at about $75,000/year of spending the marginal benefit of additional spending does not really bring most of us additional happiness. It buys pleasure and comfort, but these things don’t always bring us happiness. Now this number will change depending on cost of living and many other factors, but the principle still stands. Anecdotally I have found this to be true myself. At some point you just have enough. When I look around at my friends and other people I know there is little correlation with spending and happiness after a certain point. I know some very unhappy people in the top 1% of income.

 

Now a lot of people I know, and probably some who read this blog, are not entirely satisfied with their work (and many are outright miserable), yet many people continue to work harder and harder for that additional dollar. Take, for example, the executive that works 80 hours a week to climb the corporate ladder to increase his income from $150,000 to $250,000 and consequently hates his life. Understanding the marginal utility of spending that money can help us realize that it’s just not that important – especially at the high end of the income range.

 

Simply put, going from 50k to 75k may matter, but going from 150k to 250k probably doesn’t matter all that much even though it represents a greater amount of money. You are most likely buying comfort and pleasure and calling it happiness.

 

There are other reasons people chase a higher income of course, including ego driven attachment to their job, career, and ‘success’. Some are sacrificing to buy their freedom first. The former is usually not a good reason to earn more; the latter may be a good reason which probably warrants a whole other essay.

 

Ultimately though, we are trading a commodity which is becoming more valuable (time) for a commodity which is becoming less valuable (money).  As the end nears, time is all that matters, money has zero value.

 

It is a dilemma that doesn’t really have a solution, only tradeoffs. Trading time for money isn’t inherently good or bad, it is a choice that has consequences. As far as I can tell, most people play this game and make the trade too long.
Some people truly do not have much of a choice, but most of us do.

 

Now, the best of all worlds is to trade your time for money doing something that brings you happiness. This is a pretty good trade and the best of all scenarios; unfortunately I think this is less common than it should be.

 

Frugality

 

This is where frugality comes into play. Frugality gets a bad rap, because people associate it with cheapness, but really it is maximizing value. Frugality is finding the sweet part of the money/value curve and spending no more than necessary for contentment. Frugality is the deep understanding of this trade. It is spending on the things that matter most to you. Frugality 2.0 is the understanding of how time relates to this trade.

 

Most people will not believe me and seek to maximize their earning and spending, and if this is you I wish you a long and happy life. But for the rest of us, how can we apply this principal to bring us happiness?

 

I’ve developed a simple process that is not new (although it may be new to you). It is not complicated.

 

1. Figure out how much money you need to fulfill your basic needs: food, shelter, transportation, etc.
2. Think deeply about what in life brings you happiness (not pleasure, but happiness) and how much money above what is needed for basics you need to provide for this. This will take time and tinkering and will change over time, as what makes you happy will change as you evolve.
3. Cut out all spending from your life that does not bring you joy. Examine everything you spend money on and ruthlessly eliminate or downgrade. Optimize everything that is left over.
4. Use the saved money to buy your freedom.
5. Use your freedom to do the work you love, or do less of the work you hate.
6. If you are still working reassess and see if the trade makes sense, if not go back to step 1 and repeat until satisfied.
7. If you don’t have enough money to get past step 1 you need to figure out how to make more money.

 

It’s really pretty simple when you strip away all the distractions. Stop trading your limited time for a few fleeting luxuries and pleasures OR make sure when you trade your time that the trade brings joy in and of itself.

 

Learn when enough is enough and the trade doesn’t make sense any more. This will happen earlier than you think.

 

When people are on their death bed no one says ‘I wish I would have driven a nicer car’ or ‘I wish I would have worked harder for the company’. They regret how they spent their time or managed their relationships. They wish they hadn’t spent so much time being angry or worried.

 

Understand that frugality is not cheapness, and it is not inexpensive. You are buying something. You are buying freedom.

 

You are trading short term pleasure for freedom, with the expectation that freedom will bring you happiness, or at least the ability to pursue it on your own terms.

 

Once you frame this concept correctly in your mind, frugality does not seem like deprivation. In fact, just the opposite, it feels like abundance. It allows you to savor what truly matters and what is truly limited – your time.

 

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*Our educational system does not, cannot, and will not teach us this lesson. We are taught to be employees and consumers, work until our 60’s, and save very little. We are not taught what money is or what it represents – time. It is up to you to learn it, and if you have children it is up to you to teach them about it.

**This is actually changing constantly because our behaviors and risk factors and luck will determine probabilistically the time of our death. The overall trend is towards time being more valuable and scarce though.

 

UPDATE: Read part 2 here!

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