A sideways look at economics
For those who aren’t familiar, at Thinks and Drinks Fathom invites friends and clients to join us at a bar to socialise and discuss issues shaping the economy. Towards the end, there were three of us left with an already opened bottle of wine, and we were faced with the decision of whether to go back home, or stay to “get our money’s worth”. The day after, I realised that I had probably been subject to the sunk cost fallacy, where people choose to stick with something simply because a large amount of past resources has been invested in it. This concept applies to many situations, including business strategy. Or, if you’re Gareth Southgate, how long you wait before making a substitution.
One of the most common assumptions in economic theory is that, on aggregate, people behave in a rational way. They make the optimal decision in any given situation based on the information they have. At Thinks and Drinks, we were faced with a trade-off: whether (A) to leave our drinks unfinished, leave half an hour earlier to get a good night’s sleep and wake up rested the next morning, or whether (B) to stay for half an hour longer, finish our drinks, and wake up with a slight headache the next morning. In both scenarios, the drinks had already been paid for (thank you Fathom), so there was no extra monetary cost to either of the scenarios — any expenses that occurred were in the past. As the only benefits to staying is another half an hour of socialising, with the cost of a headache incurred the next morning, as long as you don’t value that extra half an hour of socialising over not having a headache, it would have been more rational to go home.
Sunk costs and opportunity costs are both well-known concepts in economics. A sunk cost is a cost that has already been incurred and cannot be recovered. The decision on whether to incur this cost is in the past, and therefore should not influence your future decision-making. On the other side of the coin, there are opportunity costs. An opportunity cost is the cost incurred (now, or in the future) of choosing one alternative over another. One classic example is the tradeoff between work and leisure. Say, for example, that you are faced with the option of taking all of your annual leave or give up one day of annual leave to work (with an additional day’s worth of salary). The benefit of taking annual leave is more free time that can be spent with family and friends, perhaps on holiday somewhere. The opportunity cost of taking annual leave is the salary of that extra day. For more on the tradeoff between work an leisure, see Is there such a thing as too much leave?
One example of the sunk cost fallacy is gym memberships. If you’ve paid for a six-month gym membership up-front, but a month in find out that you much prefer going for a run outside than on the treadmill; if you continue going to the gym rather than working out outside, that is not a rational decision. The sunk cost fallacy has even been used to explain why people stick to conspiracy theories, when there is clear evidence that the theory is wrong. If you’ve invested years of your time reading up on a conspiracy theory, and perhaps spent money on books or memberships in forums that reinforce your views, it can take a lot for somebody to give that theory up. Another is choosing to stick to a degree/field of study purely based on the amount of time/money invested in that degree, even if realising half-way through that you would be better off studying a different field.
So, what did we decide to do in the end? Despite being an economist, I have to admit that I don’t always behave rationally. Indeed, we stayed until the end to finish what was already paid for, ensuring no money was “wasted”. Furthermore, our decision to stay could have something to do with another well-known economic concept: people value the current period over the future period. Since the cost of the extra glass/the benefits of leaving early are incurred the next day, we didn’t care as much about this the evening before. Looking only at the current period, the tradeoff looks slightly different: you can enjoy an extra glass or two and have a nice chat, or, if you leave early, you will miss out on these benefits. This tendency to value the current period over the future period is probably enhanced when consuming alcohol, which can explain people’s tendency to consume more, even when the marginal benefit of drinking one extra glass tends to be diminishing, with the marginal cost of an extra glass (i.e. a sore head the next morning) increasing.
A friend of mine once said, “one of my most important responsibilities has always been to ensure there’s no leftover wine, a duty I’ve taken very seriously”. I’m probably more likely to continue down that path than remembering to consider the rationality of staying later to finish my drink the next time I go to the pub. However, there are situations where the sunk cost fallacy has larger consequences than lack of sleep and a sore head. For example, a business continuing to invest in a project that is costing more than it is bringing in, simply because lots of time and resources have been invested in the past. In these situations, distinguishing between sunk cost and opportunity costs can be crucial.
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