Tag: sunk costs

Rightly or wrongly, the reputation of the economics profession has taken a battering over the last 6 years. Largely this is because of the perceived inability of economists to foresee the Global Financial Crisis, and the anemic recovery that occurred afterwards in most countries. Leaving the debates over austerity vs. stimulus, liquidity traps and the zero lower bound for another day, I thought I would go back to some basic economic concepts and how, with a little bit of imagination, they can be useful in situations most people encounter in everyday life.

1. Opportunity Costs

Opportunity cost is a concept used in economics to help determine the cost of a particular action or choice. At the most basic level, the opportunity cost of doing something is the cost of NOT doing the most (economically) beneficial alternative.

For example, it is Saturday morning and you are going to drive to your friend’s house for a morning session of Call of Duty. The cost of doing this might appear to simply be the cost of gas to get there and any marginal wear and tear on the car. However, economically the cost is more than that – it also includes the benefit of the most productive activity forgone. Depending on your circumstances, that might have been picking up the breakfast shift at the local café, or putting time into that startup idea you have been working on. Whatever the case may be, you have unconsciously placed a higher value on time spent playing games then the alternative and, in many cases, that is a tangible value (the café example).

This may change nothing in your mind, you may really get a lot out of hanging out and playing games – video games are a huge industry precisely because people place a high value on playing games. But once you start consciously thinking about the cost of your actions in this manner, it tends to have an impact on how and where you spend your time.

2. Incentives

One of the parts of general economic theory that tends to rub people up the wrong way is the idea that everything can be quantified and compared. This is not a particularly romantic way to look at the world, but this line of thinking can be used to help understand and change behaviors.

For example, many people have trouble finding the motivation to go to the gym. Why is it so hard to go consistently? When you hit that sleep button on the alarm, you are making a choice based on the incentives in front of you – and you are valuing an additional hours’ sleep higher than the benefit of a gym session. There can be a range of very rational reasons for that – the benefits of any given gym session are tiny and hard to identify even if the long term benefits of consistent gym work (e.g. improved fitness, a more appealing physique) are highly valued. When you look at it that way, every morning you are faced with a choice between an immeasurably small improvement in health/fitness, or an additional hour of sleep and relaxation.

However, once we realize what the problem is, we can use incentives to reweight the choice to get the desired result. In the gym example, this can be done in a range of ways that will probably sound familiar. You can set a goal like running a half marathon – that provides additional incentive in the form of not letting yourself and/or others down or avoiding embarrassment. It could be a more immediate incentive such as treating yourself to a better lunch if you go to the gym. Organizing a gym or exercise partner will provide incentive in the form of not wanting to let your partner down by cancelling (this only really works if they don’t happen to sleep in the same bed as you). Sometimes, all that is needed is to clearly identify what the benefits will be and remind yourself of them.

Expanding this way of thinking, it can be used to look at a lot of different aspects of your life. If you have a goal to cook at home more regularly, what steps can you take to make that more appealing after a day at work (or make eating out less appealing)? Trying to commit to further study? Perhaps clearly identifying and reminding yourself of how the it will get you closer to that dream job will help provide the needed motivation.

The next logical step for this way of thinking is using it to understand the behaviors of those around you, and then utilizing that understanding to make changes. If you are a manager, how can you rearrange the incentives for the people you are managing to improve productivity or eliminate some unwanted behavior? If you have children, what incentives can you use to motivate them to help with the housework or clean up their room?

One thing to be aware of is that the incentives people are responding to can be complicated and counterintuitive. Understanding your own motivations, never mind the motivations of those around you, is something that takes time. However, the simple act of stopping to consider what may be causing you or someone else to make a choice can often lead to meaningful insights.

3. Sunk Costs

The standard definition of a sunk cost is a cost that has already been paid and is unrecoverable. In economics the concept is usually used in relation to firms (businesses), but we all deal with sunken costs on a pretty regular basis.

The classic example is where you have bought a ticket to a concert but when the day arrives you have come down with a cold (or worse). You spent all that money on the ticket so you should definitely go, right? Actually, to make the economically optimal decision in this situation, you should ignore how much you spent on the ticket (the sunk cost) and simply base your decision to go or not on whether you would still enjoy the concert more than the next best alternative (lying in bed and binge watching season 4 of the Walking Dead). Depending on how bad you are feeling, that decision could go either way.

That sounds simple right? Let’s try a thought experiment to see how difficult this can be in practice. Using the same example from above, let’s first imagine the concert ticket only cost you $10. You probably don’t have to be feeling very sick before The Walking Dead is sounding pretty appealing. Now imagine the ticket cost you $1,000. In your mind, what would it take to stop you going to that concert? Broken leg? Getting stung by an Irukandji jellyfish? If you were being rational (at least in an economic sense), you would be just as willing to forgo the concert regardless of what the ticket cost.

Applying this thinking can be tough in practice (I would have to be close to death to pass up a $1,000 concert ticket), but being conscious of it can help to avoid some poor decision-making. Should you keep pouring time and money into an unsuccessful business because you spent a bunch of money and time getting it started? You probably shouldn’t. Is it acceptable not to drink yourself into a coma after you spent money on an all-you-can-drink pass? Yes, it certainly is. It can even apply to relationships – should you continue dating your current jerk boyfriend because you have already spent 5 years with him? This isn’t a relationship advice blog, so I’ll leave that one to you, but you can see where this is going.

4. Expected Cost/Benefit

Calculating the expected cost or benefit of a set of choices can be a great way to analyze a situation where there are multiple possible outcomes, even if you don’t have specific numbers to attach to certain outcomes. Used in the right situations, it helps to identify, clarify and compare the expected outcomes of different courses of action.

Let’s look at an example where you need to decide whether to apply for a promotion or not. Let’s imagine you are in a work place and a position opens up at the next level that will be filled internally. Here is the scenario:

• The next level pays $10,000 p.a. more than your current job
• You are one of two people that can go for the position, but the other candidate is much better qualified and you believe they will get the job if they apply
• When you speak to the other candidate, they are on the fence as to whether they want the promotion (let’s say there is a 50% chance they will apply)
• Your current boss is a bit of a possessive jerk and if you apply for the job and don’t get it, you estimate he will cut your bonus by $5,000
• Your current boss can also be a generous possessive jerk, and if you don’t apply, you estimate he will bump up your bonus by $2,000 for showing loyalty

Should you go for the position? We can calculate the expected benefit/cost of each course of action to help us make the decision. Here are all the possible outcomes:

Given these outcomes, we can now weight the outcomes by the probability of them occurring to determine what the best course of action is:

Expected Benefit of Applying: 50% × -$5,000 + 50% × $10,000 = $2,500

Expected Benefit of Not Applying: 50% × $2,000 + 50% × $2,000 = $2,000

Based on this calculation, you should apply for the job, as the expected benefit is $500 higher than not applying.

Of course this is a stylized example, in reality it is unlikely that you have all the information given above. However, even missing some pieces of information, you can still use this approach to provide a baseline for your thinking. You may not know what the chances of the other person applying are, but by doing this calculation, you can determine that if there is anything more than a 50% chance of them applying, you will be better off not applying. You may not be able to estimate the impact on your bonus of an unsuccessful application, but you can work out how big the cut would have to be to stop you applying (a $6,000 cut in the above case) and then decide whether that is likely to occur. In short, you can use the information you do have to help you make your decision.

Initially it may be difficult to picture many scenarios where this type of thinking may be useful. However, with a little imagination, you may be surprised how often these situations present themselves. Some example scenarios may include:

• Trying to buy a car knowing someone else is also interested – should I increase my offer, stick to my original low-ball offer, or pull out altogether?
• Salary negotiations at work – should I accept the first offer or hold out for more money?
• Deciding who to have lunch with when you are double booked – who would be the most offended and/or who can I most easily make it up to?

BONUS POINT: Getting Over Decisions That Don’t Pan Out

One of the key benefits of approaching your decision-making in a more rational, fact-based manner (aside from hopefully better decision-making) is that there will be less regret when you make a decision that does turn out badly.

Sometimes, even when you make the correct decision based on the information you have on hand, things will turn out badly – and the reverse can also be true. What changes when you start approaching your decision-making in a more calculated way is you provide yourself with an audit trail of assumptions and reasoning used. Now, instead of wondering why you made a particular decision, you can analyze the assumptions and reasoning used and work out what, if anything, went wrong. Did I underestimate how annoyed my current boss would be with me for applying for other jobs? Did I let sunk costs influence my decision? From that point, the only thing left to do is to learn and readjust for next time.

Used any other economic concepts in your day to day life? Had any interesting experiences using the ones mentioned above? Please leave a comment and share the story!