Let's consult your inner economist on a few problems. Did you ever walk out of a restaurant without finishing a meal because you didn't like it? Would an economist say that was a wise thing to do? Suppose you intended to go to the theater. The ticket had cost $50, but as you walk up to the entrance you discover you lost the ticket. Would you buy another ticket for $50, thereby paying $100 in total? What would an economist say to do? A hospital in your town is about to be torn down to make way for a new one. It would cost about as much to renovate the old hospital, which had been extremely expensive to construct, as to build a new hospital. Would you favor renovation or construction? What do you think an economist would say? Suppose last month you paid $80 for a ticket to a basketball game in a city 45 minutes away from where you live. But tonight's the night, the star is not going to play, nothing hangs on the outcome of this game, and it's just started to snow. So, what to do? What's the best reason you can think of to go to the game? What's the best reason you can think of to stay home? And what would an economist do? Here's what an economist would do. He or she would say, well let's assume you didn't have that ticket for the basketball game. And a friend calls you up and says, hey, I have tickets for the game tonight. I can't use them. Can you? If your answer would be, great, I'll be right over. Then by all means, go to the game. But if your answer would be, you've gotta be kidding. The star's not playing. Nothing hangs on the outcome of this game. And it's started to snow. There's your answer in that case. Now, you may feel uncomfortable about not going to that game because that $80 is salient to you. But you shouldn't feel uncomfortable, and you won't in the future in this kind of situation, when you become familiar with the sunk cost principle. Only future benefits and costs should figure in your choices. Time, and energy, and money spent on some activity no longer have any relevance once they're expended. Only if that activity is valued in its own right should it be carried out. If you don't think that way for the basketball game, you're going to pay twice. Once for the ticket and once for the tedium. The sunk cost principle follows directly from the main rule of cost benefit theory. Which is, you should always choose the action with the greatest net benefit. That's benefit minus cost. And costs already expended are not included in your cost. That's not legal. The fact that the old hospital in your town was extremely expensive to build Is irrelevant. Your choice is to whether renovate it or raise it and build something else. The taxes your grandparents paid to build the old building are long gone. The decision to keep the hospital or destroy it should be made only with respect to the future. So should you eat a lousy meal that you paid a lot for? Not unless you're too poor to buy peanut butter for a sandwich when you get back home. Economists walk out of restaurants with their meal uneaten quite frequently, and they walk out of movies they paid $15 for. And they walk out of athletic events that turned out to be boring, and that they paid $100 for. The economist motto, and it should be yours, the rest of your life begins now. Now. Now. So, you find you've lost your theater ticket. Should you buy a replacement ticket? By now I assume you know the answer is yes. Unless the value of the play is less than it was when you bought the original ticket. You're not paying $100 for your ticket. The $50 is gone. It doesn't count. You're keeping the books wrong if you think about it. To see this, suppose instead of realizing at the theater entrance that you lost your ticket, you haven't lost your ticket. In fact, you haven't bought your ticket yet. But you realize that you left $50 on the counter in a pizza joint yesterday in another town. Would you now turnaround and go home rather than buying a ticket? Probably not. So, you see, it's only future benefits and costs that count. It's just as much of a mistake to include the lost ticket into your costs as it would to include the lost $50 bill. Policy makers who are unfamiliar with the sunk cost principle will often try to spend your money to rescue money they've all ready spent. And true, the X4 bomber ain't very good, but we can't afford to waste the $20 million we've all ready spent on it. Wrong. If that $20 billion has produced a substandard product, can. Drug companies sometimes try to justify exorbitant drug prices on the grounds that they need to recoup the cost of development. That's nonsense. They're going to charge what the traffic will bear. Whether the development costs were $1000 or 100 million. Many years ago my wife and I bought a summer cottage and it's put us absolutely at the edge of our finances. And we didn't have money to buy furniture. So I decided I'd build the furniture myself. Now, for some people that would be a quite reasonable thing to do. But not for me, really. Because I'm the kind of person, when I was a kid, and I built model airplanes, there were always parts left over after I had finished. So I decided I would learn how to make furniture. I'd go to classes. And after 15 hours or so of that class I had managed to build a box. And it's now dawning on me, this is crazy. I can't make furniture, it's a stupid thing for me to try to do it. It would have been smarter for me to take a part time job at McDonald's than it would to try to make my own furniture. And there's another extremely important implication of cost benefit theory. You remember you that you should choose with the action with the greatest net benefit. But if you don't, you're paying unnecessary opportunity costs. Every action has a cost, namely the net benefit, the benefit minus the cost of the second best action. Make sure that the second best action really is the second best. If it's actually better than what you were planning to do, do that instead. But we're constantly paying unnecessary opportunity costs. Economists, not so much. They don't know mow their own lawns, or wash their cars, or clean the windows to their house. There's always something else they would rather be doing. As a British economist said to me once, never do anything you can hire a small boy to do. A person who drives a car rather than taking public transportation, is going to be out of pocket for the car, the gas, the maintenance, the insurance, the garaging. That money could have been used for something else valuable, like travel or housing upgrade. But the cost of using a car in a particular occasion always seem slight. I mean, it just costs me 50 bucks to drive downtown. It feels like it's practically free, really. And every trip by a bus or subway hurts a bit. 275, just to go 12 blocks. A lot of younger people are beginning to realize this, by the way, and not buying cars. Zipcars and the like help people to have this realization. Suppose you owned an office building. And you need an office yourself. So, you say, well, I'll have an office in my own building, it's free. And actually, an accountant might say it's free, but it's not. If you could get another office just as good in somebody else's building, for less money, and rent your own out, when you were thinking you might have, to someone else for more money. You're paying an opportunity cost to keep your office in your own building. My colleagues in my psychology department frustrate me a lot on this issue. Every hire involves an opportunity cost. That's the next most qualified person that you might have hired. And sometimes the mood is, this so and so is available. Pretty darn good psychologist, we should hire him. And the question that ought to pop into people's mind and doesn't seem to do so often is, is there someone more qualified than this that we could get if we advertised widely for it? In the next section, we'll talk about two questions. One is, how do we know that the economists are right? And how can we avoid certain financial pitfalls that have been discovered relatively recently by economists and psychologists?
