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How Not to Fall for the Sunk-Cost Fallacy – Article by T. Norman Van Cott

How Not to Fall for the Sunk-Cost Fallacy – Article by T. Norman Van Cott

The New Renaissance HatT. Norman Van Cott

My wife and I frequently vacation near Asheville, North Carolina. Perhaps it’s the economist in me, but an interesting spot that I visit is the Western North Carolina Farmers’ Market. The WNC market is large (36 acres) with vendors selling every seasonal fruit and vegetable item you can imagine. Georgia and South Carolina peaches are always a highlight. Therein lies the basis for a teachable moment in economics.

Chasing Peaches

While returning to Indiana one year, we decided to stop at the market to buy peaches for ourselves and friends. Going west on I-40, we exited for the market. Turning left, we took the bridge over I-40 toward our intended exit. Since the on-ramp for I-40 east and the entrance to the market are not that far apart, we accidentally missed our exit. That was about a 6 mile mistake for me. Unavoidable costs should not figure in the decision about whether to pursue peaches.

By the time we had gotten back to the exit for the WNC market, the question arose whether we should (try again to) buy peaches. I pointed out to my wife that had we known the first time that getting to the peaches was going to entail an additional 6 or so miles of driving, we might not have ever tried to stop.

However, the gasoline, traffic delay and self-incriminating frustration associated with the 6 mile mistake were what economists call “sunk costs.” That is, there was no way to avoid them at that point. Being unavoidable means they should not figure in the decision about whether to pursue peaches. The only costs that matter at that point are the costs of exiting a second time, not both times. So we exited, bought peaches, and continued on our way.   

In retrospect, the net benefits of the peaches were less than what initially motivated us to try to buy them. The net benefits could actually have been negative, but had we not exited the second time, the loss would have been greater!

Sunken Soybeans

Let’s consider another example. Living in rural Indiana, I’ve heard farmers complain at harvest time about how the price of corn and soybeans has fallen so much during the summer. Seeing as they’re going to lose money for the year, “why even harvest” is the lament of some. This is bad thinking. At harvest time many of the costs associated with their crops are “sunk.” That is, the cost of the seed, pesticides, herbicides, fuel, etc. associated with getting to harvest time has already been incurred. Nothing can be done to get that investment back so it should be ignored. The only costs that matter at harvest time are the costs of harvesting itself. The only issue is whether lower prices will cover these costs.

When it comes to tax time those costs, previously labeled sunk at harvest time, suddenly become important in figuring farmers’ taxable income. The accountant is going to want to know them. Moreover, the IRS is going to be interested in their accuracy.

The following spring yields yet another issue. Those seeds, pesticides, herbicides, and fuel costs that didn’t matter last fall now matter, and not just for tax reasons. With planting not yet started, these costs are no longer sunk because they have yet to be incurred. If expectations are that the coming fall is to be a repeat of the previous fall, the farmers will be planting something different than corn and soybeans in the coming spring.

Sunk Costs Might Cost You a Championship

One final example. As a sports fan I have long noted the gargantuan salaries with multi-year, guaranteed contracts for professional baseball and basketball players. What’s interesting is the responses of team owners and general managers when “their” players perform below expectations. More often than not the owner or general managers will say something like “this guy’s contract means we’re paying him umpteen thousands of dollars for this season, so we have to play him to get our investment back.” Another case of bad thinking. Don’t put a bad player in the game just because you paid for them.

The player’s salary for the duration of his contract is a sunk cost. It has to be paid regardless of whether the player plays; it therefore shouldn’t figure in the decision about how much play time needs to be utilized from the player. What matters at this point is whether you can find somebody who can play better. If your favorite team(s) have owners and general managers who think sunk costs matter, I recommend you switch your allegiances.

I’ll admit that ignoring sunk costs is difficult to do. It seems like people have an innate desire to include them in their business and household decisions. But doing so can result in less than optimal decisions, which can include not being able to enjoy those large, juicy Georgia and South Carolina peaches.

T. Norman Van Cott; Economics
T. Norman Van Cott; Economics
T. Norman Van Cott

T. Norman Van Cott, professor of economics, received his Ph.D. from the University of Washington in 1969. Before joining Ball State in 1977, he taught at University of New Mexico (1968-1972) and West Georgia College (1972-1977). He was the department chairperson from 1985 to 1999. His fields of interest include microeconomic theory, public finance, and international economics. Van Cott’s current research is the economics of constitutions.

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Paradoxes, Not Contradictions – Post by G. Stolyarov II

Paradoxes, Not Contradictions – Post by G. Stolyarov II

The New Renaissance Hat
G. Stolyarov II
September 10, 2013

I am personally fond of Ayn Rand’s identification of certain matters as “paradoxes, but not contradictions”. In my view, contradictions do not exist in reality, though there may be elements that are difficult to reconcile mentally because of incomplete information or preliminary errors in one’s perception of existence.

A paradox arises when a person’s initial intuitions do not appear to hold. This means that either the initial intuitions are wrong, or one’s information is incomplete. For instance, the famous “water-diamond paradox” of Classical economics was an inability to explain why the price of water, which is essential for life, was so much lower than the price of diamonds, which, at the time, only had uses in jewelry and decoration. The 1871 Marginalist Revolution (a development independently arrived at by Carl Menger, Leon Walras, and William Stanley Jevons) resolved the paradox by explaining a key fact about human valuation that the Classical economists had missed – namely, that a person does not evaluate the entire stock of a given good, but only considers particular quantities of goods at the margin. So the paradox was resolved in an entirely rational, non-contradictory manner, by demonstrating that the abundance of water has enabled its life-sustaining uses to be fulfilled for most individuals, while the relative scarcity of diamonds means that, for most consumers, any diamond they obtain would be put to the highest-valued purpose they would find for a diamond.

I see the progress of human civilization as, in part, consisting of the increasing resolution of paradoxes. While, of course, it is possible that new paradoxes would arise as the old ones are resolved, these paradoxes arise on the boundaries of the new intellectual territory that is yet to be fathomed and incorporated into the domain of human mastery. Paradoxes, mysteries, and unresolved questions occur on the outermost edges of human advancement at any given time. As the edges expand, old mysteries and paradoxes are solved and new ones may arise in territory that was previously completely unexplored. In this sense, encountering a paradox can be seen as a challenge – a call to resolve the quandary and thereby score gains for human progress. As a meliorist who sees no limits to the potential of human reason and technology, I think that all questions are ultimately answerable and all paradoxes are solvable, given enough time, effort, and proper means. Sometimes the resolution of a paradox requires highly creative, unorthodox, and unprecedented thinking – which must transcend conventional dichotomies and posited antagonisms in order to arrive at a new understanding.