Monday, July 2, 2012

Read this and save money and time!

Good morning economists! Today I would like to discuss the concept of sunk costs in economists and how these affect the decisions we make on a daily basis. Sunk costs are costs that have been incurred (or paid for) in the past and that money can no longer be retrieved.

Let me give you a couple of examples. Suppose you buy a frozen yogurt from an ice cream kiosk. This is an example of a sunk cost. You bought the yogurt. Once you paid for it, you cannot receive your money back. Another example is buying a shirt or a pair of trousers from the sales rack at a clothing store. Usually you cannot return any clothes purchased from the sales section so the money you paid cannot be retrieved after the purchase.

Sunk costs are by definition costs that have been incurred in the past. In economics, we argue that these costs should not be taken into account when taking a future decision. Unfortunately, this is a common mistake that people make and it is costing them money, time and effort.

 Remember the frozen yogurt you bought from the ice cream kiosk? Suppose you bought the berry flavor just to give it a try. A couple of spoonfuls later you decide that you hate the taste. Do you  continue eating it because you paid for it, or, do you throw it away in disgust?

What you should realize, is that the money you paid for is completely irrelevant in your future decision making. That money is gone and is not coming back. So your decision should be solely based on the level of enjoyment the frozen yogurt provides. If you hate the taste, you should immediately throw it away. Eating the yogurt will result in disutility and will bring you a level of discomfort.

Have you ever met someone who always seems to have car trouble? I have met plenty of people who spend a fortune on fixing their cars only to break down again because they are what we describe to be "lemons" (always breaking down). I was recently talking to a friend who falls in this category and when I inquired as to why he is not selling the darn thing he replied: "But I spent so much money fixing it!"

Obviously my friend is not familiar with sunk costs. He chose to keep the car, knowing too well that it will break down again in the immediate future. He based his decisions on money spent in the past not realizing that this money is gone!

Remember, future decisions are not always based on the past.

Have a high utility day!

1 comment:

  1. So we have to investigate our money in a Chanel bag because it is an investment and a heritage at the same time!