A Good Ismaili is a Good Economist

So during the Golden Jubilee year (2007-2008), His Highness the Aga Khan was able to travel to see many Ismailies around the world. Now if you are unfamiliar with the term Ismaili, I suggest you click here.

During his travels, he had many messages to convey to Ismailis around the world and though many of them were timeless, I found only one to be extremely pertinent to 2007-2008. This message was that of frugality. December 2007 is the official month when the US recession started which has had several global effects, many OECD countries also fared pretty badly and most developing countries saw a slow-down in their growth.

Now back to the message of economic prudence, it was very simple: if you are a consumer then you should protect yourself from a future change in your income due to the economy. And if you are a producer, cut costs so you’ll be better positioned when the economic hardships start.

Well any forward looking consumer would have followed this advice without needing to be reminded. But not everyone is a homo economicus but instead we are homo sapiens, so it may be hard for many to have known the extent or magnitude of the recession and this sort of uncertainty may have delayed people’s consumption decisions. (And some of us wouldn’t have acted so even if we did know what the future held – its okay, self control and myopia are human problems).

Now here is some economics you should know: Marginal utility of consumption decreases as you consume more. Utility is a fancy name for satisfaction, and this first statement means that if you are really thirsty on a hot day and you consume two glasses of lemonade, the second glass won’t be as satisfying as the first glass. Consumers realize this, so they smooth their consumption over their lifetime. So instead of consuming all their income when they are earning the most in their 40’s (owning the fastest cars, living a lavish life) and then consuming nothing when they are retired, rational consumers spread out their consumption over their lifetime. So they’ll buy a Volvo instead of a BMW when they are rich, and be able to take trips to Florida instead of living on the street when they are poor.

Volvo's arent that bad actually

So a good Ismaili would have listened to this advice and acted like a good economist. They would have known that there is a good chance that their future income will decrease and so they would have known that their present value of lifetime resources (their net income over their life) will decrease. This in turn would cause them to decrease consumption slightly. So now lets say at the age of 30 a person was able to earn to $400,000 for the rest of their life and they intend to only live to be 70, so they would spend $400,000/40= $10,000 per year. But if they see that over the next two years their income decreases by $10,000 in each year, that doesn’t mean they decrease consumption by $10,000 each year. Instead their new smooth consumption would be 400K-20K/40 = 9.5K, so instead of decreasing their consumption by $10,000 for two years they decrease their consumption by $500 for the rest of their life.

Consumption Smoothing

So a Good Ismaili would listen to this sound economic advice to live frugally and reduce consumption; thus acting like a good economist. (In case you were wondering, the opposite does not hold, a good economist doesn’t make a good Ismaili).