Have you ever walked out of a restaurant without finishing a meal you had paid for because you didn’t particularly like it?
Do you think an economist would say that walking out under these circumstances was a wise decision?
Suppose you are just about to go into a theater to see a play for which you had bought a ticket costing fifty dollars—and you feel that’s about what the play is worth to you. Unfortunately, you have lost the ticket. Do you think you would buy another ticket for fifty dollars, thereby having paid a total of one hundred dollars to see the play?
Do you pay people to do work around your home that you don’t enjoy, such as gardening or painting or cleaning?
A hospital in your town is about to be torn down to make way for a new one. It would cost about as much to renovate the old hospital, which had been extremely expensive to construct, as to build a new hospital. Would you favor renovation or construction?
You may answer such questions differently after you’ve read this chapter. Cost-benefit theory has some implications that are subtle but profoundly important for our daily lives. These implications are almost as important as the theory’s main requirement that we choose the option with the greatest net benefit. As it happens, the implications can be derived logically from that requirement—you’re likely to realize that you violate them all the time. Finding out about them is going to save you money and time. It will also improve the quality of your life.
Sunk Costs
Let’s say you bought tickets a month ago to a basketball game in a city thirty miles from your home. Tonight is game night. However, the star is not playing, so the game is going to be less interesting than you thought it would be; and it’s begun to snow. The tickets cost eighty dollars apiece. Do you still go to the game or do you resign yourself to staying home? WWED? What Would an Economist Do?
An economist would tell you to do a thought experiment: Suppose you hadn’t bought the tickets. You intended to, but it slipped your mind. And suppose a friend called you and told you he had tickets to the game but wasn’t going himself; you could have his tickets for free. If your answer would be, “Yes, that’s great; I’ll be right over to pick them up,” then you should by all means go to the game you paid for. But if your answer would be, “You’ve got to be kidding. The star isn’t playing and it’s starting to snow,” then you shouldn’t go to the game even though it means your money got you nothing. If you feel uncomfortable making that decision, it’s because you haven’t fully incorporated the sunk cost principle into your decision making.
The sunk cost principle says that only future benefits and costs should figure in your choices. The money you paid for the basketball game is long gone—it’s sunk—and you can’t get it back by going to the game. You should go to the game only if you think your net benefit would be positive. Go if you would say to yourself, “Well, the star isn’t playing and it’s snowing, which is a pain. But I really feel like watching a game tonight. I’ve read all I care to in the newspaper and there’s nothing on TV.” Otherwise, don’t go to the game because that would constitute paying a cost to justify a cost that can’t be retrieved.
The fact that the old hospital in your town was extremely expensive to build is absolutely irrelevant to a choice of whether to renovate it or raze it and build anew. The taxes your grandparents paid to construct that hospital are a dim memory, and they’re not going to reappear because you’ve decided to let it stand. A decision to keep or destroy that hospital must be made only with respect to the future. The net benefits for what you get in the way of a new hospital compared to the net benefits of a renovated hospital are the only considerations that count.
Should you eat a lousy meal that cost a pretty penny? Not unless you’re too poor to buy peanut butter to make yourself a sandwich when you get home. You might ask for your money back if you found a fly in your soup, but you’re probably not going to demand to see the manager and tell him that you’re refusing to pay for the crummy lasagna. So the money for the meal is sunk. No point in incurring the additional cost of eating the darn thing.
Should you walk out of a movie that cost fifteen dollars, which you’re not particularly enjoying and which shows no prospect of getting better? Absolutely.
The economist’s motto, and it should be yours, is that the rest of your life begins now. Nothing that happened yesterday can be retrieved. No use crying over spilt milk.
Policy makers who are not economists often spend your money for no better reason than to rescue money they’ve already spent. “True, this weapon system is not very good, but we’ve already spent $6 billion of the taxpayers’ money, and we don’t want to waste that.” You should remind your representatives of the adage “Don’t throw good money after bad.” That bad money is sunk. Even more sinister is the politician who urges continuing a war, putting more lives at risk, “so that the fallen shall not have died in vain.”
Drug companies sometimes justify exorbitant prices for a drug by citing the need to “retrieve the cost of developing it.” They’re pulling your leg. The development money is gone. They’re going to charge whatever the market will bear for the new drug—even if the development costs for the drug were very small. They get away with their claim because the public doesn’t fully understand the concept of sunk costs.
A little warning, though. If you begin to live in awareness of the sunk cost principle, you’re going to make the occasional mistake. I no longer walk out of plays—because I began to realize it could be demoralizing to the actors when they see that empty seat after intermission. And I no longer ask my wife whether she wants to stay to watch the rest of a movie that’s boring me silly. A couple of times we had an awkward exchange: “Do you like this movie?” “Well, kind of. But we can leave if you want.” “No, that’s okay, I don’t mind staying.” And then we both sit there unhappy—my wife because she knows I’m staying in my seat even though I don’t want to, and I because I’ve lessened her pleasure in the movie.
Speaking of spouses, some people I know, after encountering the sunk cost concept, have suggested it means people shouldn’t stay in a marriage just because they’ve spent a long time and a lot of energy in the marriage—because that time and energy are sunk. I would be very careful about that kind of reasoning. Time and energy spent in a marriage do count as reasons to stay in it. If the time and energy had value previously it may have value in the future. Consider the saying “Marriage is for getting over the periods of unlove.”
Opportunity Cost
It used to bother me that my mother would drive all over town to get the best bargain on detergent by cashing in two dollars’ worth of coupons she had clipped from the paper. There was a hidden cost to that driving around. Money was being spent for gas and maintenance on her car. Moreover, she could have been reading a novel or playing bridge, activities that I think she valued more. In other words, she was incurring opportunity costs by driving around town looking for bargains.
An opportunity cost is defined as the cost of engaging in a given course of action, thereby losing the benefits of the next-best action. This principle holds where resources are limited and the chosen action precludes taking any other action. The cost is not the sum of the unchosen alternatives but just the best unchosen alternative. Anything of value can figure into opportunity costs—money, time, or pleasure.
A farmer who raises wheat forgoes the benefit of raising corn. A child who successfully tries out for the school soccer team may be forgoing the pleasure of playing football for the school or playing in the orchestra.
Life is full of opportunity costs. They can’t be avoided. What can be avoided is paying an opportunity cost for an action that is less valuable to you than some other action you could just as easily have taken.
Economists don’t mow their lawns or wash their cars. But should you mow your own lawn? Only if (a) you enjoy doing it or (b) you’re so low on cash that you can’t afford the luxury of lying in a hammock and watching your fourteen-year-old neighbor mow it. If you mow your own lawn, there are other things you can’t do that you might enjoy more—working in the garden, for example, which might give you more pleasure both in the doing and in the result.
The person who drives a car rather than taking public transportation is out of pocket for the car, plus gas, plus maintenance, plus insurance—money that could have been used for travel or a housing upgrade. But the cost of owning a car tends to be hidden after it’s bought, and the cost of a daily commute by bus and the occasional cab ride is quite salient. So the cost of driving a car seems slight (I’ve got the thing, might as well use it), whereas every trip by another means hurts a bit (fifteen bucks just to go downtown?!). As it happens, many young people have learned the principle that every car trip usually costs a lot by comparison to the alternatives. They’re buying fewer cars than their parents (helped along in this by the appearance on the scene of Zipcars and their imitators).
A person who uses an office in a building the person owns is likely to consider the office to be rent-free. And an accountant might indeed record her as paying nothing for rent. But in fact she is paying something for using the office, namely the payment for the office if she were to rent it out. If the person could find an office that was as good or better than her own, but that costs less money than what the person could get for her own office, she is paying an opportunity cost for using her own office. That cost is hidden but nonetheless real.
There’s a familiar slogan I find helpful in avoiding opportunity costs: “There ain’t no such thing as free lunch.” (The expression comes from Depression-era bars that attracted patrons by advertising free lunch. The lunch was free but the beer wasn’t.) Any action you take means you can’t take some other action that, upon reflection, you might prefer.
Entry-level construction and factory jobs are beginning to pay more now that home building is taking off and some manufacturing is returning to the United States. Should colleges increase student aid to attract young people who might be tempted to go for one of those jobs? An economist would point out that as salaries go up, so does the opportunity cost of going to college. If tuition at the university is $10,000 per year and the potential student could make $40,000 per year in a construction or factory job (up from the $30,000 it was a few years ago), the opportunity cost of going to college has been increased by $40,000 (assuming graduation in four years). Most economists would say it’s proper for the university to respond to this opportunity cost by providing more scholarship aid to lower-income students. But I know from my own research that most academics rebel at that. “I don’t want to bribe people to go to college.”
It can sometimes be quite difficult to see that the value of the unchosen alternative is actually greater than that of the chosen alternative. Every hire you make for your company constitutes an opportunity cost. If there’s no one more capable who can be hired, it’s tempting to feel that nothing has been lost. But if there are good reasons to believe that in the near future someone more qualified could be hired, then the present hire involves an opportunity cost to the company that might indicate that hiring should be put off.
It’s important to keep in mind that there are costs for being too aware of opportunity costs just as there are for being too aware of sunk costs. When I was in graduate school, I had a friend who was great fun to be with. He was always coming up with interesting things to do. If we went for a walk, after a while he might suggest that we take a bus across town to see a parade. Partway through the not terribly interesting parade, he might note that if we got a quick dinner, there would be just enough time to see a new movie we both wanted to see. After the movie, he might suggest we visit a friend who happened to live in the neighborhood.
Now, each change in activity my friend suggested, taken just by itself, was an improvement over the current activity, thereby avoiding an opportunity cost. But taken as a whole, my time with my friend was less enjoyable than it would have been without the constant calculation of new pleasures to be had. Calculation of opportunity costs can be a cost in its own right.
And back to my mother. I eventually realized that my attitude that shopping is a necessary evil to be curtailed as much as possible is not everyone’s attitude. My mother would rather hunt for bargains than do most of the other things she does. Plus it’s an excuse to get out of the house. So I was wrong to feel my mother was incurring net opportunity costs by her shopping.
Are the Economists Right?
How do we know that the economists are right—that we should make our choices in line with cost-benefit theory, including its sunk cost and opportunity cost corollaries?
What do the economists have to say that might convince us? They make two arguments.
1. Cost-benefit theory is logic-tight. It’s based on a few assumptions that most people agree are reasonable guides for good decision making: more money is better than less, decision time counts as a cost, future benefits are of less value than present benefits, and so forth. If you agree with the assumptions, then you must buy the model because it follows mathematically from the assumptions.
2. Less common, and possibly usually made tongue-in-cheek, is the argument that cost-benefit analysis must be beneficial because corporations pay for experts to apply cost-benefit analysis to their operations. Corporations are not dumb, and they know what they want, so by implication cost-benefit rules are the correct ones to abide by.
Are you convinced by these arguments? I’m not.
Deriving appropriate behavior from a logical construction is just not very persuasive to me. An argument can be logical without being correct (see Chapter 13 on formalisms). Before we can accept an argument based on logic, we need to consider how our susceptibility to social influence and a host of other factors that operate outside of consciousness might make formal arguments less than completely convincing. And remember from the previous chapter that optimization was the normative recommendation before Herbert Simon came along and said that it’s actually satisficing that’s the best policy. And there’s not much evidence that satisficing is what people actually do or even what they’re capable of doing. So maybe they’re right not to satisfice. Maybe there is another principle they’re following that some theorist in the future is going to recognize as the most rational strategy, given our cognitive limitations. A good normative theory for how to make choices needs to take into consideration the Part I issues of rationality, the extent to which we are capable of self-knowledge, and the appropriate role of the unconscious in decision making. Because most psychologists believe these things, they tend to be dubious about economists’ descriptions of choice behavior and their prescriptions for it.
Corporations pay for cost-benefit analysts, all right. But they also pay for handwriting analysts to assess personality, lie detector technicians, feng shui “experts,” motivational speakers to hop around a stage, and astrologers. None of these is proven to be effective. Astrology has been shown to have no predictive validity whatsoever, and there’s a great deal of evidence indicating zero validity of both lie detectors and handwriting analysis for any purpose a corporation might care about.
So what would convince you that you ought to use the cost-benefit principles?
What if you knew that the more familiar people are with cost-benefit principles in the abstract, the more likely they are to use them? That would be somewhat persuasive to me. As economists would be the first to insist, we must presume people to be rational until proven otherwise. If people change their behavior in order to be consistent with the abstract principles once they know them, that counts as evidence of a sort that the principles are useful.
And in fact, Richard Larrick, James Morgan, and I have found that people do use cost-benefit principles in proportion to how much they have been taught about them.1 Economics professors are far more likely to endorse choices made on the basis of cost-benefit principles than are biologists or humanities professors. Students who have had economics courses are more likely to know the principles in the abstract and more likely to report making choices consistent with them than students who have not had economics courses (though not much more likely).
But findings such as these are contaminated by self-selection (see Chapter 11). People are not randomly assigned to be economists versus something else such as lawyers or bricklayers. Maybe economists are smarter than biologists, or maybe they were sympathetic to cost-benefit issues before they became economists—in fact became economists precisely for that very reason. And maybe students who take economics courses are smarter than students who don’t and are more likely to understand and use the rules independent of how many economics courses they’ve taken.
Of course, for the above alternative explanations to be viable, it would have to be the case that, other things being equal, smarter people report making choices more in line with economic theory than people who are less smart. This is in fact the case. SAT and ACT verbal scores are a pretty good proxy for IQ. The correlation between SAT (and ACT) verbal score and reported use of the rules is about .4—not a huge correlation but certainly not trivial in its implications for how people should lead their lives.2 (The correlation holds both for students who have taken economics courses and for those who haven’t.)
I’ve conducted experiments showing that teaching cost-benefit principles to people in brief sessions—presenting even less material than you’ve seen in this chapter—increases the likelihood that they will endorse choices made using those principles. Even when people are tested weeks later, in the context of a telephone poll apparently unrelated to the experiment, they’re more likely to endorse choices that follow from the rules.
So smarter people, and people educated in the rule system, are more likely to use the principles than less smart, untrained people. Are they better off doing so? If they’re so smart, why aren’t they rich?
They are richer, actually. Faculty members at the University of Michigan who report making decisions in line with cost-benefit analysis make significantly more money.3 The relationship is even stronger for biologists and humanities professors than it is for economists (perhaps because all economists are well aware of the principles and there isn’t much variation among them in that respect). And the more economics training the biologists and humanists have had, the more money they make. Moreover, I’ve found there is a strong tendency for raises over the past five years to be correlated with the degree to which faculty report using cost-benefit principles for their choices.
Students who report making choices in line with cost-benefit rules get better grades than students who don’t. And it’s not just because the rule users are smarter. In fact, the relationship between rule use and grades gets stronger when verbal SAT/ACT is pulled out of the equation. At every level of verbal ability, it’s the students who use the rules more who get the better grades.
Why should use of cost-benefit rules make people more effective? In part because use of the rules encourages you to focus your energy where it will do the most good and drop projects that don’t look like they’re panning out. Avoiding the sunk cost trap and attending to opportunity costs, in other words. Some of the best advice I ever got was from a person who told me to have three categories of projects: very important and urgent, important and should be done soon, and somewhat important but no rush. Then make sure you are only working on the first category at all times, never on the other two. Not only will you be more effective, there will be more time left to goof off and enjoy yourself. (Though I do make an exception for activities with unknown payoff that might produce food for thought—especially if they’re pleasurable in their own right. Henry Kissinger’s advisor urged him to stop studying political science and start reading more novels.)
Summing Up
Expended resources that can’t be retrieved should not be allowed to influence a decision about whether to consume something that those resources were used to obtain. Such costs are sunk, no matter what you do, so carrying out the action for which the costs were incurred makes sense only if there is still a net benefit from it. No point in eating sour grapes just because they were expensive. Corporations and politicians get the public to pay for goods and projects in order to justify past expenditures because most people don’t understand the sunk cost concept.
You should avoid engaging in an activity that has lower net benefit than some other action you could take now or in the future. You shouldn’t buy a thing, or attend an event, or hire a person if such an action likely blocks a more beneficial action. At least that’s the case when immediate action is not strictly necessary. You should scan a decision of any consequence to see whether opportunity costs may be incurred by it. On the other hand, obsessive calculation of opportunity costs for small matters is a cost in itself. True, you can’t have chocolate if you choose vanilla, but get over it.
Falling into the sunk cost trap always entails paying unnecessary opportunity costs. If you do something you don’t want to do and don’t have to do, you automatically are wasting an opportunity to do something better.
Attention to costs and benefits, including sunk cost and opportunity cost traps, pays. The thinkers over the centuries who have urged some form of cost-benefit analysis are probably right. There’s evidence that people who make explicit cost-benefit decisions and avoid sunk costs and opportunity costs are more successful.