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Sunk costs

In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs    , which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.

Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is feeling kindly, Selena will not get a refund. But staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.

For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. But the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.

From a model with two goods to one of many goods

The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. Or in more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that was presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.

Key concepts and summary

Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must give up something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of choices available. The slope of the budget constraint is determined by the relative price of the choices. Choices beyond the budget constraint are not affordable.

Opportunity cost measures cost by what is given up in exchange. Sometimes opportunity cost can be measured in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that must be given up.

Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.

Problems

Use this information to answer the following 4 questions: Marie has a weekly budget of $24, which she likes to spend on magazines and pies.

If the price of a magazine is $4 each, what is the maximum number of magazines she could buy in a week?

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If the price of a pie is $12, what is the maximum number of pies she could buy in a week?

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Draw Marie’s budget constraint with pies on the horizontal axis and magazines on the vertical axis. What is the slope of the budget constraint?

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What is Marie’s opportunity cost of purchasing a pie?

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References

Bureau of Labor Statistics, U.S. Department of Labor. 2015. “Median Weekly Earnings by Educational Attainment in 2014.” Accessed March 27, 2015. http://www.bls.gov/opub/ted/2015/median-weekly-earnings-by-education-gender-race-and-ethnicity-in-2014.htm.

Robbins, Lionel. An Essay on the Nature and Significance of Economic Science . London: Macmillan. 1932.

United States Department of Transportation. “Total Passengers on U.S Airlines and Foreign Airlines U.S. Flights Increased 1.3% in 2012 from 2011.” Accessed October 2013. http://www.rita.dot.gov/bts/press_releases/bts016_13

Questions & Answers

what is microeconomics and macroeconomics
Usman Reply
microeconomic deal with the study of individual firms and household and macroeconomics deal with the economy as a whole.
Ebenezer
difine VAT,, and give advantage and disadvantage VAT
Barack
definition of Monopoly
malonzy Reply
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it broaden one's mind
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it help us to make good choices
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business economics is the way the society uses its limited resources to satisfy their unlimited wants
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Sunday Reply
demand means desire for a commodity backed by willingness & ability to pay for that commodity
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Akoheni
supply means suppliers supplying more commodities when price's high or less when price's low to satisfy human want
Prince
the coefficient of price elasticity of supply is the measure of percentage change in the quantity supplied of a good due to a given percentage change in its price.
Khushiba
Please what is Economics of Scales?
Prince
what is cardinal and ordinal utility?
Khushiba
Cardinal utility is the satisfaction derived by the consumers from the consumption of goods and services while ordinal is ranked in terms of preference.
Grace
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Khushiba
Please explain what is meant by Economic Integration?
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economics scales I don't know but I know laws of returns to scale
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can someone help explain to me what is fairly inelastic dd
TIMAH
Economics Economics - The study of how people use their limited resources to try to satisfy unlimited wants
Abdullah
Economic integration has been one of the main economic developments affecting international trade in the last years. Countries have wanted to engage in economic cooperation to use their respective resources more effectively and to provide large markets for member-countries of the resulting integrate
Abdullah
Inelastic Demand When consumers are relatively unresponsive to price changes. A PED coefficient of less than one means that a particular change in the price of a good will be met by a proportionally smaller change in the quantity demanded.
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demand refers to goods and services that a consumer is willing and able to buy at given rate over a given period of time
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Demand  - The entire relationship between the quantity of product that buyers wish to purchase per period time and the price of that product..
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economics is study of scarcity and how humans make decisions.
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when a person is part 50% rational and the other part of him is 50% focused on money as an incentive
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must find out the problems originating from and take remedy for it.
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Economics as a social science Discuss
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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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