After completing this lesson, you will be able to:
- Identify the opportunity cost of an action
- Understand how sunk costs influence our decision making
Economist often study how rational individuals make decisions. An important component of this decision making process is how people treat opportunity costs. People are typically good at managing scarcity when it comes to money, but they often behave irrationally when valuing their time or money that is unrecoverable.
In the scene below, Glenn is sharing his weekend experience with his co-workers. He and his wife had gone to see the movie Saw, mistaking the horror film for a movie about carpentry. He shares how he threw up in his lap, but his wife still wouldn’t let him leave because the movie tickets were non-refundable.
Explicit versus Implicit Costs
Glenn shares that he was on a date with his wife, Jerusha. Have students list the costs of a date, and be sure to have them identify the explicit costs of data as well as the implicit costs.
Explicit costs will include things like dinner, parking, movie tickets, and any snacks they may have purchased. Implicit costs would include the value of their time, which they could spend working. In Glenn’s case, it would also include the embarrassment and discomfort of sitting through a movie as he did.
Once we know the costs of our decisions, we have to determine if the benefits we receive outweigh those costs. It’s tough, but not impossible, to measure the benefit of being happy. Typically, decision making for binary options happens in 3 steps:
- Add up all the benefits of the action
- Subtract all explicit and implicit costs
- Choose the option that makes you happier
Glenn and Jerusha are stuck at a decision point after they show up and Glenn throws up during the movie. They can choose to get up and leave or they can sit through the rest of the movie.
Have students list out the benefits and costs of each action. Benefits of staying may be that they end up enjoying the movie, while the benefits of leaving include getting out before Glenn throws up again. The benefits are a bit easier, but see if students mistakenly include the cost of the movie ticket in the decision process!
It’s important to realize that not all costs should be considered in the decision making process. If the tickets are non-refundable, it doesn’t really matter if Glenn and Jerusha stay for the rest of the movie or if they get up and leave. By sitting through the rest of the movie, they have fallen victim to a very common fallacy.
A sunk cost is considered a cost that is unrecoverable. Because Glenn and Jerusha can’t get that money back it really shouldn’t be a factor in determining whether they stay through the movie. It was an explicit cost in determining whether they wanted to go out on a date, but once they’re out on that date that money can’t go back into their bank account.
Before students leave, present the following question:
Which of the following statements about sunk costs is FALSE?
- Sunk costs are ones that cannot be recovered, no matter what future action is taken.
- Sunk costs are irrelevant for decision making because they cannot be recovered.
- If sunk costs are large enough, they can affect future decision making.
a) Only #2 is false
b) Only #3 is false
c) Both #2 and #3 are false
d) Both #1 and #3 are false
D — Sunk costs shouldn’t affect future decision making, but when they are significantly large enough, they often affect people’s decisions.