Is it rational to ignore some costs?
After reading Chapter 7 you will have been exposed to the basic paradigm in economics--namely, the rational man (homo economicus) model. The model posits that much of human behavior can be explained as if individuals made their day-to-day decisions by comparing the marginal benefits and marginal costs of various activities. For example, consider the decision facing a customer at Burger King. Let's imagine that our rational man has already consumed one Whopper. Should he buy (and eat) a second Whopper? Well, if the marginal benefit of another Whopper exceeds the marginal cost, then it is rational to gobble up another Whopper. What about a third Whopper? I suspect that at some point the marginal benefit of an additional Whopper will start to decrease (how much happiness can a third Whopper possibly give you?) such that it's not "worth it" to buy another one. Thus, the marginal benefit/marginal cost rule tells us "how much" to do of something. Namely, continue the activity up until the point where MB = MC.
Marginal analysis, by its very nature, is forward-looking. A rational individual is always trying to compare the additional benefits versus the additional costs of her behavior. Not all costs, however, show up in the future. Some costs may have been incurred in the past and, consequently, are unavoidable. These are called sunk costs. According to homo economicus, sunk costs should be ignored.
Read the following episode from the life of Alex Tabbarok Do you think Alex made the right choice?
What are some other examples of sunk costs that people ought to ignore if they wish to emulate homo economicus? Can you point to anything from your own personal experiences?
5 comments:
I feel that Alex did not make the right choice. I mean if his gut reaction was to veg out upon arriving from home, then whatever he needed to purchase most not have been that important. It seemed to me that it must have been a spur of the moment purchase or perhaps a craving and not a necessity.
An example of a sunk cost that is something that recently happened to me. I wanted to live somewhere that was close to where I worked. Now I could have chosen to stay at home for free but it wasn't close to my place of work. I chose to stay in an apartment that required a nonrefundable deposit of $250. Situations changed and I was unable to live in the apartment. I then left for home. Angry at having wasted 250 dollars on the first apartment, I at first did not want to look for another apartment due to the living costs. However since I felt it necessary to live close to my work place the first time around, I still found it important to live close in the end. So even though I had already wasted money on an apartment. It was a sunk cost.
I believe that Alex did make the right decision. In the article it stated that once he did decide to head back he felt better. This means that the overall benefit was more than the cost. He also realized that no matter what he did he could not get the time he had already wasted back. If it would not have made him feel better than he would have made the wrong decision and should have stayed home but that was not the case.
Recently, I experience an example of a sunk cost. I just spent money to charge my AC unit in my car. I did not realize that I had a bad link and in no time the AC was not working. Now I must spend the money to get the AC fixed and charged again. The original cost to charge the AC is a sunk cost.
Given the national average cost of gasoline, at the time, of $1.52 (http://tonto.eia.doe.gov/dnav/pet/hist/mg_tt_usM.htm)per gallon, and thinking like the rational man, then yes, I think Alex did the right thing. However at today's gasoline prices and thinking like a real person, I would have to say no, because if he was misfortunate enough to have left his wallet at home then that's his own dumb luck and he should not waste the gas and wear and tear on his vehicle for another trip to the store. Chances are his intened purchase was going to cost less than the gallon of fuel and the added mileage will.
I don't experience too many times when I have the freedom to forget a sunk cost, if I forget something at the store, regardless of how important an item it may be, I have to wait until my next trip to town. Gas prices are just too high to ignore and when you live 20minutes from town and only get 16 miles/ gallon you learn to minimize your traveling.
However, I do have one example to share. My husband just put new brakes on my Blazer, then I had to take it to our mechanic for a new rear-end. During the course of repairing my vehicle, the mechanic replaced my rear brakes as well, because they were already worn down, metal-to-metal. The cost of the first set of brakes, only 2 months old, was the sunk cost here.
Alisha, you've misunderstood the rational man model. You can not say that Alex's intended purchase was going to cost less than the gallon of gas and the wear and tear on his car. Furthermore, it doesn't matter what the wear and tear costs.
Let's imagine Alex was going to go watch the latest Indiana Jones movie. Furthermore, let's imagine that Alex values the movie at $30 (i.e., his marginal benefit).
Now, suppose that the price of the movie ticket is $8 and that the cost of gas and the wear and tear on his car amounts to $10.
Thus, from Alex's point of view, the net benefit from seeing the movie is $12 ($30 minus $18).
Given that Alex initially choose the movie over all other uses of his time, we can infer that the movie was his number one choice--that is, all other uses of his time generate net benefits of less than $12.
Now, suppose that Alex forgets his wallet and must return home. Should he go back to the movie?
The initial $10 spent on wear and tear is a sunk cost. There's no way for him to recover that money.
But if he doesn't go to the movie, he will forgo the net value of the movie (namely, the $12). This would represent a real opportunity cost to whatever else Alex decides to do.
Alex made the right decision because not only was he able to rationalize it to himself emotionally but he was also able to back it up with economic evidence. The marginal benefit of him going out for a second time was greater than that of the marginal cost of staying in, and not going and doing whatever he was going to go to do at the store. In staying home not only would he not have gained back the lost time, but he would have not gained what he was going to get when he intially left, before he left his wallet at home. By returning to the store, he was able to not regain time, but he was able to gain his purchased goods.
I recently delt with sunk costs when going to Ghana with the college. When ordering food at a resturant I did not know that it was part of their culture that if you did not give them exact change you would not get change back, so many times I would not have exact change on me and would be out a couple bucks because I didn't have the exact change.
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