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Economics Teaches Us Not To Fret

Mises Daily: Tuesday, February 12, 2008 by


Economists emphasize the importance of the concept of opportunity cost. TANSTAAFL — "there ain't no such thing as a free lunch" — pervades the discipline. In a world of scarcity, every choice requires that something else of value must be given up, and the highest-valued alternative given up is the opportunity cost.

That opportunity-cost emphasis focuses on the question of what is actually being given up when a choice is made. Its purpose is to ensure that we don't mislead ourselves with basic errors, because if we misunderstand the relevant costs, our understanding can well be incorrect even if our theory from that point on is correct (following the maxim that logic only means making no more mistakes than you are already committed to). Equally important, it helps ensure that others can't mislead us with their confused understanding, as so often happens when people try to sell government "solutions" to perceived problems (e.g., ignoring the cost to society of the taxation required to fund some spending program).

Unfortunately, the opportunity-cost concept — that the relevant cost of any choice is the highest-valued alternative foregone — may be simple to understand, but it can be difficult to apply the principle consistently in the complex "real world."

One illustration economics professors often use to make this point is to ask students about the opportunity cost of attending a particular class. We use it to demonstrate that the first part of the answer to almost any such general question is "it depends" (because there are so many factors that can change the relevant costs or benefits of a particular choice) and that good judgment is necessary to apply the concept adequately.

Should the cost of driving to school be counted as part of the cost of a student attending a particular class session? It depends. Would you have come to school even if you skipped that class? If so, it is not part of the cost of attending that class. If not, it is part of the cost.

Assuming you should count the cost of driving to school, should that cost include depreciation? It depends. Is it based on mileage or age? Only depreciation based on mileage should be included, because the car will get older whether you drive it or not.

But if the car is leased, depreciation wouldn't matter, except as reflected in the fee for any extra miles over your lease limit.

What about insurance? It would count if you paid insurance only on each day you drive, but not if you paid for 6 months coverage at a time.

And what if it is Dad's car, not yours? What about gas? Do you pay or does Dad?

One helpful reminder to appropriately apply the opportunity cost concept is that "sunk costs are sunk." Because what is in the past cannot be changed by a current decision (except on Wikipedia and in history textbooks), treating something that won't be changed by a choice as a relevant opportunity cost of that choice is a mistake. Yet people violate this principle all the time. For example, people who overpaid for an asset often refuse to sell it because they "can't afford to take the loss," even though they have already borne the cost of their mistake, and selling that asset afterward doesn't cause the loss to change — it only forces one to admit that they made a mistake.

Further, I must confess that despite my training as an economist and my constant "preaching" of the concept to my students, I caught myself violating in practice the rule that I preach in class.

I was attending an event that was going to last about 3 hours. But during most of it, I kept thinking about another event I wanted to attend at the same time, but was missing. Thinking about that substantially undermined my enjoyment of the event I was at.

After the fact, I realized that since I would not have been able to get to the event I wanted to attend from the event I was at, even if I left immediately, it was no longer a viable option. Therefore the value I placed on the other event was no longer a cost to staying where I was. It was an opportunity cost of deciding where to go only at the time I made that choice. But once that choice was made, it was a sunk cost, and no longer relevant. Yet I acted as if it was relevant, and my sunk-cost mistake made me worse off, undermining my experience.

Further reflection made me see that I have fallen victim to this sunk-cost error more than once. For example, when I am doing something with family or doing something to relax, my workaholic nature tends to keep whispering to me that, because I have so much to do, I should be "at it."

Focusing on what has already been given up once my choice has been made imposes costs without any corresponding benefits.

Once I have chosen what I will do, those whispers should be treated as the sunk costs that they are. Whenever I have chosen the "wrong" option, I have already borne the cost. Fretting about it further is to compound the loss because of a failure of logic.

I must admit that having made such a sunk-cost mistake in applying my own supposed expertise is embarrassing. It doesn't make what I know any less true, but it reminds me of my dad's golf-course advice: "Do as I say, not as I do." However, it made me think more carefully about how tricky this point can be. When I am making a choice, I must remember the relevant opportunity costs, or I will mislead myself into mistakes. Then, having made a decision, I must not think about what I gave up, or I will mislead myself into different mistakes. Unfortunately, the ability to think in different ways before and after the same choice, often in rapid succession, does not come naturally.

$20 $15

This difficulty may partly explain an old criticism of economists as those "who know the cost of everything but the value of nothing." Given that its primary use has been by politicians and their beneficiaries who want to create smokescreens to defend boondoggles against careful consideration, those who see through and point out such nonsense should take that ad hominem attack as a point of honor rather than as an insult. And if we are looking at current costs to more effectively make choices about whether to continue a prior choice (as with all those "automatic" government spending formulas that politicians hide behind to pretend there is nothing they can do about them, despite their claimed desire to), then that is entirely defensible. However, to the extent that we continue thinking about the costs of something once a choice has really been made, it can be a valid criticism, and a mistake to avoid.

I have begun a self-imposed "cognitive therapy" to stop letting thoughts of sunk costs undermine my enjoyment of life (and it has started me thinking in other directions as well, as of the distinction between efficient guilt — which motivates future change, so that there are both costs and benefits — and inefficient guilt — which makes us feel worse, but does not motivate change, so that there are costs but no benefits).

I am sharing these thoughts in the hope that they can help others who suffer from the affliction of sunkcostitis. Of course, if the opportunity cost to someone of acknowledging the affliction is too high, that will open up an entirely new range of issues to consider.

Gary M. Galles is a professor of economics at Pepperdine University. Send him mail. See his archive. Comment on the blog.