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Investment vs. consumption 1

The difference between investment and consumption. Created by Sal Khan.

Video transcript

I've been wanting to make a video on a couple of terms that people have really thrown around for a while now. And I think it really hits the core of some of the issues we're dealing with now with the credit debacle but it's kind of at a deeper level. So the things I want to go over are the ideas of savings, consumption, and investment. And you hear these a lot. Everyone obviously says, I've invested in the stock market or I've invested in a house and I really want to give you a framework for how I think about these ideas. And frankly, I haven't seen them depicted this way in any economics book, although they've kind of touched on this, but I think this is really how you should think about these things. So if you save money, and I think we all know what that means, that's money that you didn't spend, there's a couple of things that you can do with it. You can either consume your money or you could invest your money. So, let's just think about a bunch of different situations and think about whether those things are consumption or investment. So let's say, I have $100,000 that I'm dealing with. So let's say, I take that $100,000 and I build a factory. And I think that that factory is going to be able to produce-- I'll make up some product-- it'll be able to produce cars more efficiently and cheaper than any other car factory out there. Well, I think we'd all agree that this is an investment. And why is it an investment? Because I'm taking this $100,000 and I'm putting it to some use that is creating, hopefully, more value than my original $100,000. In fact, I'm expecting some type of a return on this investment. And I've made a bunch of videos on what a return on investment is, and you can usually quantify it. If I take a $100,000 and I build this factory and this factory spits out $50,000 a year, it's probably creating at least $50,000 a year value, assuming that nothing corrupt is happening in our system. In fact, it's normally creating more than $50,000 a year of value. It may be creating a $100,000 a year of value and $50,000 of that may be going to the person who's doing the production and then the other half of the value is actually going to the consumer of whatever this factory is making. And you have to think about it, because if all of the value went to the person who produced the factory then there's not a huge incentive for someone to use his products anymore. But anyway, that's not the topic of discussion. We're just trying to get at a mental framework on what consumption is versus investment. So I think we all agree that if I were to build a factory that this is-- let's say I'll do everything in green as investment. So building a factory is an investment. Now let's say that I'm homeless and I have this $100,000. And because I'm homeless, I don't have a place to go and eat dinner and rest and relax. Because I don't have that, I can't get a job and I can't become a productive member of society. So maybe, I'm going to use this $100,000 to buy a simple house that meets all of my needs. Let's say build a simple house, and I'll do that in a neutral color. This is my other use of this $100,000, instead of building a factory, I'm going to build a simple house. And this house, it provides shelter for me and my family, it allows us that security that now my kids can go to school and they can themselves become more productive citizens. I now have an address. I have a place to take a shower, that allows me to go get a job and I can now create value for society as a whole, instead of being on the corner and begging for money from people. I would argue that this is also an investment. Why is it? Because I'm taking this $100,000, that maybe I had or someone gave to me, and it's generating a return. And what is that return? Well, with a factory, it's maybe a little easier to quantify. But at minimum, it's this work that I'm able to do because I now have a house. Because I have the security, I have the address. I have the shelter. I'm able to relax. It's that security and it's also the return that probably my kids are going to be able to now contribute to society. Maybe if they grew up homeless, they would have never been able to contribute. And now that they have a roof over their head, and are able to go to school, et cetera, they are going to be able to give some economic value back to society. It's hard to value, maybe I didn't have any job before and now I have a job and I can contribute $30,000 a year to society. Maybe I'm working at someone's factory. Maybe I'm providing some other-- maybe I'm a farmer now. Whatever, I'm providing some source of value. And maybe my kids-- if they never got an education, they would have maybe added $10,000 of value per year to people and now they can add $20,000 of value. So that difference would also be some of the return on this investment. So I also consider this to be an investment. Now, my question to you is, let's say that I already had a house-- so this is an investment. Let's say I already had a house and my family is happy and we have everything we need. We have food on the table and my kids go to school and I'm able to get a job and all of that exists. But let's say, I still have a $100,000 and I use that $100,000-- I'll do it in yellow-- to put in some granite counter tops. I have some money left over, let's say, I'm going to add a bathroom to my house and I will put the latest hardwood floors, so that my family will be impressed. You can imagine. And maybe I add 2,000 square feet. You normally can't get all that for a $100,000 but I think you'll bear with me. So I'm essentially doing some major home improvements. So my question to you is-- is this an investment or is this consumption? Now, in our everyday world, with most people we deal with, they will call this investment in my house. And why are they saying that? Because they say, by spending a $100,000 in the house in this way, that maybe-- if you watch the Home and Garden channel, they're doing this all the time-- that if you pour this a $100,000 into your house, that maybe the value of your house is going to increase by $150,000. Or someone else, all of a sudden, is going to perceive the value of your house as being $150,000. They'll say, well, you got a $50,000 return on investment. I'd argue that that is not investment. That it's speculation. You are, essentially, piling money into this stuff-- and I'll do this in red, consumption is red. What's happening here truly economically? When you add granite, or you add an extra bathroom or hardwood floors or this extra 2,000 square feet, is it making anyone who's living in that house more productive? Is it making you harder working; is it making you more likely to invent the cure for cancer, or more likely to invent a way of getting cheap energy, or produce more widgets? No, it's just, if anything, providing more things for you to have to take care of, that you're not going to be able to focus as much on your work. Or more energy is going to have to be extended to maintain this type of place, to heat and cool a 2,000 square foot house. So if anything, by actually pouring the $100,000 here, you're actually creating something that is going to suck more out of society. In fact, in no way is this going to contribute to the collective wealth of society. The last two examples I gave contribute to the collective wealth society, some of which you share, and that is your return on the investment. But as a whole, this is an investment into society. And it's going to make the pie bigger. This right here, does not make the pie bigger. It might make you a little bit happier, make your ego feel a little bit better, let your pride grow, and your self righteousness grow, and show other people that you've arrived, but it's not going to increase the wealth of society. And when you say that you've invested, you are really just saying I've speculated. What you're saying is-- by paying this $100,000, you're going to find, essentially, a greater fool out there. They could have done the same thing, they could have bought your house, spent $100,000 and done this, if this is what would have made them happy. But what you're saying is, essentially, that you're going to find somebody out there who's willing to pay $150,000 extra for something that should have only cost $100,000. And in fact, if anything, if you use this at all, the value of this is going to go down. So you're just somehow assuming that the granite counter tops that you choose are going to be the taste that someone else would like or that the hardwood floors are going to be the taste someone else would like. I would actually argue that when you customize your house in this way, you are creating $100,000 of consumption to your taste. And I'd be surprised if someone else, truly, is willing to pay more than $100,000 unless they're being, in some way, irrational or they can finance this because it's part of the mortgage. Anyway, this is, I think, just the big picture: investment adds value to society. A simple house adds value to society. Consumption is something where people might call it an investment because it's kind of speculation. One might find some other guy willing to emotionally pay more for something. But it's money that's burned; it's not creating more value for society. I continue this in the next video.