2.2: Income and Expenses

Learning Objectives

1. Identify and compare the sources and uses of income.
2. Define and illustrate the budget balances that result from the uses of income.
3. Outline the remedies for budget deficits and surpluses.
4. Define opportunity costs and sunk costs, and discuss their effects on financial decision-making.

Personal finance is the process of managing one's finances to support a life and a way of living. Just as a business must be financed - its buildings, equipment, use of labor and materials, and operating costs must be paid for - so must a person’s possessions and living expenses. Just as a business relies on its revenues from selling goods or services to finance its costs, so a person relies on income earned from selling labor or capital to finance costs. You need to understand this financing process and the terms used to describe it. In the next chapter, you’ll look at how to account for it.

Where Does Income Come From?

Income is what is earned or received in a given period. There are various terms for income because there are multiple ways to earn it. Income from employment or self-employment is wages or salary. Deposit accounts, such as savings accounts, earn interest, which can also be generated through lending. Owning stock entitles the shareholder to a dividend, if there is one. Owning a piece of a partnership or a privately held corporation entitles one to a draw.

The two fundamental ways of earning income in a market-based economy are by selling labor or selling capital. Selling labor means working, either for someone else or for yourself. Income comes in the form of a paycheck. Total compensation may include other benefits, such as retirement contributions, health insurance, or life insurance. Labor is sold in the labor market.

Selling capital means investing: taking excess cash and selling it or renting it to someone who needs liquidity (access to cash). Lending is renting out capital; the interest is the rent. You can lend privately by direct arrangement with a borrower, or you can lend through a public debt exchange by buying corporate, government, or government agency bonds. Investing in or buying corporate stock is an example of selling capital in exchange for a share of the company’s future value.

You can invest in various other types of assets, including antiques, art, coins, land, or commodities such as soybeans, live cattle, platinum, or light crude oil. The principle is the same: investing is essentially renting capital or selling it for an asset that can be resold later, generate future income, or both. Capital is sold in the capital market and lent in the credit market - a specific part of the capital market (just like the dairy section is a specific part of the supermarket). Table 2.2.1 shows the sources of income.

Table 2.2.1 : Sources of Income

	Work	Invest	Lend
Trade	Sell Labor	Sell Capital	Rent Capital
Return/ Income	Wages or Salary	Profit or Dividend Capital Gain (Loss)	Interest
Market	Labor Market	Capital Market	Credit Market

In the labor market, the price of labor is the wage that an employer (buyer of labor) is willing to pay to the employee (seller of labor). For any given job, that price is determined by many factors. The nature of the work determines the education and skills required, and the price may also reflect other factors, such as the job's status or desirability.

In turn, the skills required and the attractiveness of the work determine the supply of labor for that particular job - the number of people who could and would want to do the job. If the supply of labor exceeds the demand, meaning there are more people available to work at a job than are needed, then employers will have more hiring choices. That labor market is a buyers’ market, and the buyers can hire labor at lower prices. If fewer people are willing and able to do a job than there are jobs available, then that labor market is a seller’s market, and workers can sell their labor at higher prices.

Similarly, the fewer skills required for the job, the more people will be able to do it, creating a buyer's market. The more skills required for a job, the fewer people there will be to do it, and the more leverage or advantage the seller has in negotiating a price. People pursue education to enhance their skills and, therefore, become more competitive in the labor market.

When you are starting your career, you are usually in a buyer's market (unless you have some unusual gift or talent), if only because of your lack of experience. As your career progresses, you have more (and perhaps more varied) experience and presumably more skills, and so can sell your labor in more of a seller’s market. You may change careers or jobs more than once, but you would hope to do so to your advantage — that is, constantly gaining bargaining power in the labor market.

Many people love their work for many reasons other than the pay, however, and choose it for those rewards. Labor is more than a source of income; it is also a source of many intellectual, social, and other personal gratifications. Nevertheless, your labor is also a tradable commodity and has a market value. The personal rewards of your work may ultimately determine your choices, but it is essential to be aware of the market value of those choices as you make them.

Your ability to sell labor and earn income reflects your situation in the labor market. Earlier in your career, you can expect to earn less than you will as your career progresses. Most people would like to reach a point where they no longer have to sell their labor at all. They hope to retire someday and pursue other hobbies or interests. They can retire if they have alternative sources of income, such as earnings from savings and capital sales.

Capital markets exist so that buyers can buy capital. Businesses often require capital and have limited options for raising it. Sellers and lenders (investors), on the other hand, have many more choices of how to invest their excess cash in the capital and credit markets, so those markets are much more like sellers’ markets. The following are examples of ways to invest in the capital and credit markets:

• Buying stocks
• Buying government or corporate bonds
• Lending a mortgage

Where Does Income Go?

Expenses are costs for items or resources that are used up or consumed in the course of daily living. Expenses recur (i.e., they occur repeatedly) because essential items such as food, housing, clothing, energy, and other necessities are used up daily.

When income is less than expenses, you have a budget deficit - too little cash to provide for your wants or needs. A budget deficit is not sustainable; it is not financially viable. The only choices are to eliminate the deficit by (1) increasing income, (2) reducing expenses, or (3) borrowing to make up the difference. Borrowing may seem like the easiest and quickest solution, but borrowing also increases expenses, because it creates an additional expense: interest. Unless income can also be increased, borrowing to cover a deficit will only increase it.

Better, although usually harder, choices are to increase income or decrease expenses. Table 2.2.2 shows the choices created by a budget deficit.

Table 2.2.2 : Budget Deficit

Income Less Than Expenses = Budget Deficit
1. Reduce Expenses	= consume less	= reduce budget deficit
2. Increase Income	= sell more labor or capital	= reduce budget deficit
3. Borrow	= increase (interest) expenses	= increase budget surplus

When income for a period exceeds expenses, a budget surplus occurs. That situation is sustainable and remains financially viable. You could choose to decrease income by, say, working less. More likely, you would use the surplus in one of two ways: consume more or save it. If consumed, the income is gone, although presumably you enjoyed it.

If saved, however, the income can be stored, perhaps in a piggy bank or cookie jar, and used later. A more profitable way to save is to invest it in some way - deposit it in a bank account, lend it with interest, or trade it for an asset, such as stocks, bonds, or real estate. Those ways of saving are ways of selling your excess capital in the capital markets to increase your wealth. The following are examples of savings:

1. Depositing into a savings account at a bank
2. Contributing to a retirement account
3. Purchasing a certificate of deposit (CD)
4. Purchasing a government savings bond
5. Depositing into a money market account

Table 2.2.3 shows the choices created by a budget surplus.

Table 2.2.3 : Budget Surplus

Income Greater Than Expenses = Budget Surplus
1. Increase Expenses	= consume more	= reduce budget surplus
2. Reduce Income	= sell less labor or capital	=reduce budget surplus
3. Save and Invest	= increase income	= increase budget surplus

Opportunity Costs and Sunk Costs

In personal finance, there is always an opportunity cost. You always want to make a choice that creates more value than cost, and therefore, you always want the opportunity cost to be less than the benefit from trade. You bought the jacket instead of the boots because you decided that having the jacket would bring more benefit than the cost of not having the boots. You believed your benefit would be greater than your opportunity cost.

Opportunity costs affect not only consumption decisions but also financing decisions, such as whether to borrow or to pay cash. Borrowing has obvious costs, whereas paying with your own cash or savings seems costless. Using your cash does have an opportunity cost, however. You lose any interest you may have earned on your savings, and you lose liquidity.

When buyers and sellers make choices, they weigh opportunity costs and sometimes regret them, especially when the benefits from trade are disappointing. Regret can color future choices. Sometimes regret can keep us from recognizing sunk costs.

Sunk costs are costs that have already been spent; that is, whatever resources you traded are gone, and there is no way to recover them. Decisions, by definition, can be made only about the future, not about the past. A trade, when it’s over, is over and done, so recognizing that sunk costs are truly sunk can help you make better decisions.

Unlike a price tag, opportunity cost is not obvious. You tend to focus on what you are getting in the trade, not on what you are not getting. This tendency is a cheerful aspect of human nature, but it can be a weakness in the kind of strategic decision-making that is so essential in financial planning. Human nature may also cause you to focus too much on sunk costs, but no amount of relish or regret can change past decisions. Learning to recognize sunk costs is important in making sound financial decisions.

Summary

• It is essential to comprehend the sources (incomes) and uses (expenses) of funds, as well as the resulting budget deficit or budget surplus.
• Wages or salary are income from employment or self-employment; interest is earned by lending; a dividend is the income from owning corporate stock; and a draw is income from a partnership.
• Deficits or surpluses need to be addressed, which means making informed decisions about how to manage them.
• Increasing income, reducing expenses, and borrowing are three common ways to address budget deficits.
• Spending more, saving, and investing are three ways to deal with budget surpluses.
• Opportunity costs and sunk costs are hidden expenses that affect financial decision-making.

Exercises

1. Where does your income come from, and where does it go? Analyze your income inflow from all sources and expenditure outflow for a month, quarter, or year. After analyzing your numbers and converting them to percentages, show your results in two figures, using proportions of a dollar bill to show where your income comes from and proportions of another dollar bill to show how you spend your income. How would you like your income to change? How would you like to see your distribution of expenses change? Use your investigation to develop a rough personal budget.
2. Examine your budget and distinguish between wants and needs. How do you define a financial need? What are your fixed expenses, or costs you must pay regularly each week, month, or year? Which of your budget categories must you provide for first before satisfying others? To what extent is each of your expenses discretionary, under your control in terms of spending more or less for that item or resource? Which of your expenses could you reduce if you had to or wanted to for any reason?
3. If you had a budget deficit, what could you do about it? What would be the best solution for the long term? If you had a budget surplus, what could you do about it? What would be your best choice, and why?
4. You need a jacket, boots, and gloves, but the jacket you want will use up all the money you have available for outerwear. What is the opportunity cost of buying the jacket? What is your sunk cost if you buy the jacket? How can you modify your consumption to minimize the opportunity cost? If you buy the jacket but find that you need the boots and gloves, how could you modify your budget to compensate for your sunk cost?