Wednesday, December 21, 2011

The Economics of Life : Sunk Costs

As an economics major, I can affirm the rumor that economics is more general, more theory-based, and less hands-on than the other business majors. Unlike my friends that are accounting majors, I’m not learning specific skills that I will use when I graduate. However, I’d like to think I’m learning about life. (That sounds so cliché, but it’s true!) When my professors aren’t rambling on about which economists won Nobel Prizes, I seem to be learning theories that further make sense when applied to situations we face in everyday life. Let me explain….

Theory 1: Sunk Costs

In Theory: In economics, sunk costs are simply costs that have been incurred and cannot be recovered. Economic theory teaches us that sunk costs are not relevant in decision-making. In other words, when you make a decision, you should not consider any costs that cannot be regained; only future costs should affect a decision. The reasoning behind this is that if we were to let sunk costs affect our decisions, then we are not logically evaluating that decision based on its own merits.

Purchase decisions: You buy a pair of really expensive (but really nice) shoes. Of course you’re so excited to wear them, you ignore the pain that they cause you in the beginning, thinking that you’ll wear into them. But soon enough, those pumps are doing unthinkable damage to your feet. What in the world was this shoemaker thinking? But you can’t possibly throw them out. After all, you spent last month’s rent on them. Right?
We do this all the time! It may not be shoes, but I’m sure at some point in your life you bought something that you regretted, but you felt the need to use it because you spent so much money on it.
Let’s look at the situation using the theory of sunk costs, shall we?
The purchase of your expensive (but really nice) shoes is a sunk cost. That means that the money spent on them is gone, non-refundable. So that cost, however large it may be, is now irrelevant to the decision to continue to wear the shoes. Let’s look towards the future: those beautiful shoes are killing you, and the more you wear them, the more you damage your feet. So let’s call this the utility of wearing the shoes (which is very low). On the other hand, if you stop wearing the shoes, you won’t incur extra costs, since you (hopefully) don’t own one pair of shoes, and also, your feet won’t hate you, so utility would be greater.
If we look at the situation this way, it’s pretty clear right? I mean, it’s obvious that we should stop wearing the shoes? Wrong! Too often, when faced with similar situations, we aren’t able to let go of what happened in the past. We think about how we would be losing the sunk costs (“But I spent so much money on the shoes!”) But sunk costs are not recoverable.

Relationships: We often hear about people that stay in unhealthy and unhappy relationships. And the reason is usually something along the lines of, “But when we met, he/she was such a good person…” or “Things never used to be this bad…” You know how something inside of you just wants to scream at that person? It’s because deep down inside, you know about rational decision making. You know that the past doesn’t matter if the present and the future don’t look good. And that, in essence, is the theory of sunk costs.

We’ve all heard it before: “Don’t dwell on the past.” As human beings, we can’t help but to focus on our yesterdays, because after all, our history is what defines us. What we often fail to do is focus on the future. The future holds the unknown; we fear its randomness. What we should try to realize is that by controlling the situations in our present by looking ahead instead of looking back, we can make more rational decisions (unclouded by past judgment) and in a sense have some control on our futures.

So focus on your futures. Yesterday is history, but tomorrow may not be a mystery…

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