By Kristie Engemann, Public Affairs Staff
Chances are, you don’t have a Ph.D. in economics. If you do, welcome! If not, never fear.
You’re likely just curious how to leverage economic thinking to shape your everyday decisions—which is perfect, since the study of economics is fundamentally about choices.
While I don’t have a doctorate in economics, luckily, I get to work with some very sharp economists who study decision-making at a microeconomic (individual) and macroeconomic (collective) level.
Recently, I chatted with B. Ravikumar, a senior vice president and deputy director of Research at the St. Louis Fed. Ravi was kind enough to explain three concepts that can help you the next time you make a choice, big or small:
A sunk cost is one that has already been incurred and cannot be recovered. In business, this could be pumping money into R&D for a new product or hiring a consultant for a study. Maybe these benefit your firm by yielding more profitability—awesome!
But say they don’t. If the product isn’t viable or the study isn’t useful, it’s not logical to keep dumping more money and effort into these sunk costs.
This one makes me think of Kenny Rogers’ “The Gambler”: You gotta know when to hold ’em, know when to fold ’em…
As Ravi explains, “One example of using economics to solve a common dilemma is what’s known as the ‘sunk cost fallacy.’ Let’s say you’re in a movie and you already paid the cost of the ticket. You’re watching the movie, and the movie is just terrible and, at this point, you have to make a decision: Do I continue watching the movie or do I quit?”
The typical fallacy people make, Ravi says, is that “I’ve already paid for the ticket, I might as well as watch the entire movie. But the economist’s calculation would be: OK, how much is your time worth for sitting in the movie compared to walking out?”
Ravi suggests asking yourself, “Is this movie going to get any better? If your forecast is that it’s not going to get any better, you’re better off walking out—because whether you stay or you walk out, your money is sunk. The ticket’s already paid for.”
He speaks from experience, having known when to walk away prior to attaining his economics pedigree.
“I have actually walked out of a movie,” he says. “A long time ago, I was in college, and we walked out. This was before I started taking economics classes. It was so terrible, we didn’t even need the economist’s calculation.”
Bottom line: The next time you’re spending money to repair an old car, or letting unworn clothes occupy valuable space in your closet, recognize that you can’t recover a sunk cost. Continuing to allocate time, money or effort toward something going nowhere fast is not worth it.
I bet you’ve heard the expression, “There’s no such thing as a free lunch.” The concept of opportunity cost makes this clear. When you chose to eat your free lunch, you sacrificed the opportunity to do something else—finishing a project, taking a walk, having coffee with friends.
Opportunity cost describes the value of the next-best alternative. In the case of lunch, we’re evaluating your personally limited resource of time.
Economics tells us there are limited resources to produce goods and services in a world of unlimited wants. Every day, we all grapple with scarcity.
Ravi gives another example as food for thought. It’s around a topic that St. Louis Fed experts have written a lot about: Is it worth it to attend college?
“Typically, when you think about going to college, economists would say you want to compare the costs and benefits. So, the ‘cost’ of going to college includes the obvious one, the direct cost: tuition, books, etc.,” he says.
“But there’s also an opportunity cost,” Ravi explains.
“If you hadn’t gone to college, you would have earned something as a result of your high school diploma. … If you’re going to college for four years, what you’re giving up is this opportunity cost of your time—you could have earned something during that time.”
On the cost side, he says, you should account for direct costs (tuition, books, etc.) as well as opportunity costs.
On the benefit side, “you should take into account whatever you can possibly get as a result of graduating from college.”
Bottom line: When you make a choice, what did you sacrifice to acquire it? Expand your thinking beyond what’s right in front of you. That can help you determine your choice’s full “costs.” Check out recent blog post for other this real-life examples of evaluating opportunity cost.
Say that I drafted this article and listed only two ways to think like an economist. That doesn’t seem like enough!
To provide three, I evaluated my “costs” to produce one more example—in this case, time and coffee. I already had my computer fired up, my mug at the ready, my talk with Ravi top of mind, and my brain in the zone.
Note that I wasn’t thinking about the average amount of time and caffeine (say, 30 minutes and one cup of coffee apiece) it took to produce three examples for you. Rather, I was thinking about the additional cost (20 minutes and half a cup) of what it would take to produce this example, No. 3.
In other words, I got “marginal.”
Ravi explains …
“Marginal is a very common word in economics meaning something quite different than what typical society refers to as marginal. We refer to lots of decisions using the term marginal.”
For non-economists, he says, the word may signify fringe or trivial. “But in economics, it means something very, very different. It means decisions made on the margin.”
Indeed, the word marginal describes the effects from one more of something.
Some examples that you may hear in economics are:
“Going back to the movie and education examples, people should think in terms of the marginal decision,” Ravi advises. “Should I spend one more year accumulating skills? Should I spend one more hour watching this particular movie? Should I spend one more dollar buying this particular commodity? Those are the marginal decisions.”
“You’re asking the question, what is the next dollar good for? What is the next unit of time good for? What is the next degree good for? So that’s the marginal decision,” he says.
Bottom line: Just like making peace with sunk costs … and considering what you gave up to make a choice … economic thinking means evaluating decisions at the margin. What will one more of something cost you? Or what is it worth to you?
You can discover Ravi’s work here on our Research site. And check out these recent blog posts: