1.3 Opportunity Costs and Sunk Costs Lecture

Understanding Costs

• Types of Costs

  • Costs are typically marked with a price tag.

  • However, costs extend beyond just monetary expenses.

Opportunity Cost

• Definition

  • Opportunity cost refers to the value of the next best alternative that is forgone when making a choice.

  • It is crucial for both life decisions and economic choices.

• Example: Choosing to Attend College

  • Obvious costs: tuition, room and board.

  • Opportunity cost:

    • If one could earn $30,000 a year working instead of studying, then this is the foregone income.

    • If someone could earn $5,000,000 a year as a singer, going to college becomes significantly more costly in terms of opportunity cost.

The Relation of Opportunity Costs to Choices

• Changes in opportunity costs can influence decisions even when direct costs remain constant.

• Example of Free Offers:

  • Promotions for free food may be appealing, but the real cost involves the time spent waiting.

  • Opportunity costs of waiting:

    • Time with friends or potential earnings (e.g., $10/hour).

Decision-Making and Trade-offs

• Importance of understanding opportunity costs for making informed decisions, whether dealing with food offers or major investments.

Common Mistakes in Evaluating Opportunity Costs

• Students often mistakenly consider all alternatives when assessing opportunity cost.

  • Example:

    • If one chooses to go to a party over movies or studying, the opportunity cost is the movie, not both.

• Costs include emotional factors like hurting a friend’s feelings when not attending an event.

Sunk Costs

• Definition

  • Sunk cost refers to expenses that have already been incurred and cannot be recovered.

• Example:

  • If you buy three tacos but only eat two, the cost of the third taco is a sunk cost; it shouldn't affect the decision to eat it or not.

• Behavioral Insight

  • Rational choice suggests ignoring sunk costs when making future decisions.

• Example of Poor Decision-Making:

  • Continuously repairing a car that has already incurred prior expenses (e.g., $3,000) does not justify further spending if it is no longer a viable option.

  • Businesses also fall into this trap, continuing to invest in failing products because of past expenditures.

• This concept can also extend to personal lives, such as remaining in a long-term but unhealthy relationship due to time and resources already invested.

Conclusion

• Recognizing that costs encompass not just the price but also opportunity and sunk costs is vital for effective decision-making.