I hope you remember my post on Scarcity. If not, go read it now. For those too lazy to click twice, scarcity deals with our decisions and how we make the most of our scarce (ha!) resources. If you were too lazy to click and read you deserved that bad joke.
Human decisions are fallible. We make mistakes. How many times have we looked pack at photos and thought "what was I thinking when I wore that?" We also make errors in our logic - even if we are fully informed regarding all the options. Surprisingly, most of us make the same errors. For those who see this as an opportunity to make new errors - challenge extended.
Sunk Costs.
Sunk costs are just that...sunk. Think of it as a shoe expo. We pay $10 for admission to the expo to check out new shoe styles. We just paid $10. Now, at what point does what we paid become an issue? Does this impact how long we stay?
From an economic standpoint - we should stay as long as we are happy. It doesn't matter if we stay 10 minutes or four hours, the cost is the same. That means the cost is sunk. It is in the past. It's paid. It is not relevant to the current decision on how long to stay. One the cost is incurred (the admission price) it should not carry weight as to any future decisions. We should, economically speaking, only focus on potential marginal costs, the future and which current option is the most beneficial to us.
While at the shoe expo, a marketing rep comes up to us and offers us $500 and a free handbag to leave the shoe expo and go to the handbag expo across the street. Do we turn down the $500 and free handbag because we don't believe we have gotten our $10 worth from the shoe expo? Ummmm, NEGATIVE. We book it across the street praying for a Hermes Birkin. This is a rational decision. Seriously. Even from an economic standpoint. We net $490 + a new handbag.
Suppose I bought a pair of adorable kitten heels for $250. The purchase made me happy. The kitten heels made me purr (sorry, couldn't resist). I wear them once. A friend offers to give me a pair of $500 shoes. These are also adorable. I am getting ready to go out and I have a new dress to wear. The shoes my friend offers me match the dress perfectly, but I think that I need to wear the kitten heels just because I paid $250 for them and do not feel I have gotten my money's worth out of them yet. That is an irrational decision from an economic standpoint. Sunk costs are sunk.
Dollars and percents. Costs and benefits.
$10 and 10% are not the same. This seems pretty simple, right? Many, many, many people will drive an hour or more to save 10%, incurring much more in additional cost than the amount of money they would save. How? I'm glad you asked. :-)
Example: A local store has a Coach handbag for $100. A store an hour away has a 10% off sale on that handbag. The handbag there will cost only $90. Before the hate mail starts, I know a Coach handbag for $100 is crazy, but this is my fantasy, ok?
The same local store has a matching key fob for $20. The competitor an hour away has the key fob for $19.80. Would you even consider the drive to save twenty cents?
You think you are being smart by shopping the sale in the first instance, right? Wrong.
Gas prices right now are $3.50 a gallon and your car only gets 20 miles to a gallon. (I told you to buy that Prius) So, estimating a 120 mile round trip in your car you will use six gallons of gas (120/20=6). This is a cost of $21.00. It will cost you $21.00 to travel to buy that purse at the 10% discount. If the purse is 10% off $100, the price will be $90. This is a $10 savings. After you pay for gas (not to mention mileage, wear and tear...) your will have lost $11.00. In this instance it is a better deal to buy the handbag locally. In the second option, well, you just paid double for a key chain. Does that make you feel good?
Let's say that same local store has Jimmy Choo pumps for $650 (it's a heck of a sale). The same store above - an hour away - has the same shoes on sale for 10% off. We know that gas will cost us $21. 10% of $650 is $65. We will save $44 (net) by making the trip.
This is a good economic decision. While we are there, we might as well pick up the Coach handbag and key fob, too. This is a $55 savings and a rational decision because we weighed the costs and the benefits of our decision. Costs and benefits are absolute. A two hour round trip HAS to be thought of in terms of costs and benefits, not percentages.
Average and marginal are not the same. It's like white and winter white.
This builds more on the cost and benefit theory discussed briefly above. The important thing in this decision is to look at the marginal costs - not the average ones. The average cost is the total cost of making that product divided by the total number produced. A company can make 1000 handbags for $5000. This is a cost of $5 per handbag. Marginal costs are the costs incurred by making one more item. The company wants to make 1001 handbags. This cost will be $5050. The marginal cost is $50. This also makes the average cost increase to $5.04 per handbag. While marginal and average costs are not the same, they are interlinked. Looking at both the average cost and the marginal cost helps make better financial decisions.
