Economics Teaches Us Not To Fret
In a world of scarcity, every choice requires that something else of value must be given up, and the highest-valued alternative given up is the opportunity cost.
That opportunity-cost emphasis focuses on the question of what is actually being given up when a choice is made. Its purpose is to ensure that we don't mislead ourselves with basic errors, because if we misunderstand the relevant costs, our understanding can well be incorrect even if our theory from that point on is correct (following the maxim that logic only means making no more mistakes than you are already committed to).
Equally important, it helps ensure that others can't mislead us with their confused understanding, as so often happens when people try to sell government "solutions" to perceived problems (e.g., ignoring the cost to society of the taxation required to fund some spending program). FULL ARTICLE
Comments (8)
Your mention of 'sunkcostitis' rings true.
However the pervasiveness of the phenomenon is wired deep into the human psyche, if not into the DNA itself. Probably conditioned by our palaeolithic past, we humans have an asymmetric approach to gain versus loss, such that we regret loss about twice as much as we value the equivalent gain. tHE SAME phenomenon too manifests itself in reckless gambling behaviuour where gamblers on a losing streak will chase their losses with higher bets, in order to recoup, but wont risk as much when they are not in the hole. Now that is insane by any standard, but it is the same cognitive error, wired in as it were. .
This phenomenon is well covered in Michael Shermer's recent book 'the Mind of the Market: compassionate apes, competitive humans and other tales from evolutionary economics'.
Strange, I havent seen a review of the book from Mises. org to date. Shermer , while not a 100% full blooded Austrian economist, and making some suggestions that may not sit well with fundamentalist Libertarians, still displays a very strong leaning towards AUstrianism, and indeed and praises LvM himself for his magnum opus, Human Action.
Id love to see one of the Mises luminaries give this book some thoughtful attention in this forum, and perhaps critique its content. Im not nearly qualified enough to do it justice beyond saying I enjoyed reading it very much. Just as it is rare to see an economist who knows anytrhing about biological evolution, and its rare to see a biologist who knows anything about economics, its refreshing to see someone with such deep understandign of both fields.
He gives pretty good coverage to a lot of the neuro- and psycho- research thats been done into how people approach different value judgments, decisions, and uncovering the universal, cross-cultural elements of human attitudes to fair play, self-interest, altruism, ( which seem pretty consistent across all cultures, suggesting their common origin). And of course, Shermer declares a strongly free-market , nay, libertarian ethos as the most natural institution compatible with the human self-interest combined with a drive to reciprocal altruism and the inevitable tension that these competing imperatives create in each of our own minds, every time we face a choice.
A worthwhile read, imho.
Published: February 12, 2008 9:07 AM
Further, I must confess that despite my training as an economist and my constant "preaching" of the concept to my students, I caught myself violating in practice the rule that I preach in class.
I was attending an event that was going to last about 3 hours. But during most of it, I kept thinking about another event I wanted to attend at the same time, but was missing. Thinking about that substantially undermined my enjoyment of the event I was at.
After the fact, I realized that since I would not have been able to get to the event I wanted to attend from the event I was at, even if I left immediately, it was no longer a viable option. Therefore the value I placed on the other event was no longer a cost to staying where I was. It was an opportunity cost of deciding where to go only at the time I made that choice. But once that choice was made, it was a sunk cost, and no longer relevant. Yet I acted as if it was relevant, and my sunk-cost mistake made me worse off, undermining my experience.
Thank you professor Galles for sharing this enlightening insight.
What I find most interesting about it is what it demonstrates about the nature of human action. In professor Galles' example, one can clearly see that the enjoyment of his experience (his "well being" or "happiness") is impacted in a real way, as he changes his thoughts between concentrating on the lecture at hand and the other lecture that was missed. No goods are being exchanged here in the common understanding of the term. No economic transactions are taking place here in the common understanding of the term. But it is clear in the example that his happiness is impacted in a real way.
The reason is because "thinking" is action, in the sense of goal directed activity.
Here is Mises (Human Action, pg. 99, section V. Time, sub-section 1. Time as a Praxeoogical Factor):
"Man's inability to accomplish this makes thinking itself an action proceeding step by step from the less satisfactory state of insufficient cognition to the more satisfactory state of better insight."
Professor Galles' example demonstrates that in "trying to" change how he views the idea of sunken costs in order to improve his own well-being (avoid undermining his experience), he is "acting" in that very activity.
Thus again, we are able to glimpse Mises's insight that praxeology is the general science of human action, of which economics is but a branch or sub-section.
Man acts in "trying to". Action is goal directed activity, and is not identical to economic activity, as Mises again and again repeats.
Professor Galles' example shows that when we merely reflect on the nature of action we can see the patterns of action which Mises devoted his life to studying.
Published: February 12, 2008 11:01 AM
"In a world of scarcity, every choice requires that something else of value must be given up, and the highest-valued alternative given up is the opportunity cost."
Is this not similar to crying over spilt milk?
We are constantly, practically every minute
confronted with decision making. We come to a fork in the road and can't but take one path. Times moves on, should we backtrack the situation again is different , it is impossible to tell beforehand which is the absolute best decision to make.
Does this not make "opportunity cost" pure speculation and a waste of time?
Tax forms are due to be filled, April 15 is fast approaching. I believe inflation is about
10%, my bank is reluctantly paying me 1% interest and the tax man is taxing the meager 1% interest. 'opportunity cost"?
give me a break!
Published: February 12, 2008 12:39 PM
"Does this not make "opportunity cost" pure speculation and a waste of time?"
It makes crying over bad decisions a waste of time, that is for sure.
Published: February 12, 2008 12:54 PM
"Does this not make "opportunity cost" pure speculation and a waste of time?"
as inquisitor says, agonising over spilt milk is pointless. however, it is important to recognize how significant a factor regret/remorse is in decision-making.
a large part of technical analysis in speculative markets is based around support/resistance levels, which in turn reflect emotional attachment to prices already paid (ie spilt milk). "averaging down" is a classic investment error coming from this all-too-human trait.
br'er rabbit and the tar baby (joel chandler harris) covers the same ground.
Published: February 12, 2008 7:33 PM
Excellent piece Gary! I believe you have hit on why I never worry. I took that lesson on sunk costs and internalized it- now I only make decisions on the margin, at the moment of the fork in the road.
Published: February 12, 2008 11:39 PM
I think it's safe to say that politicians suffer greatly from sunkcostitis, because they're unable to stop throwing good money after bad rather than admit their mistakes, cut their losses and move on.
Also, I know someone who suffers from a severe case of sunkcostitis. Their entire life has been devoted to the idea that everything MUST turn out the way they want (even when it is obvious to everyone else that it can't). As a result, their life is a train wreck.
If this individual were to devote only 10% of the time they currently spend obsessing about fixing that which can't be fixed and instead were to focus on more productive and positive pursuits, they might have a shot at a successful and happy life. Instead, their life is a vicious cycle of repeated failed attemtps to make past mistakes work out.
At the same time, they resent all others who are able to let go of past mistakes and harass and sabotage the efforts of anyone who tries to move forward. They especially hate to see others succeed.
Published: February 14, 2008 5:40 AM
"The characteristics of individual men, their ideas and judgments of value as well as the actions guided by those ideas and judgments, cannot be traced back to something of which they would be the derivatives. There is no answer to the question why Frederick II invaded Silesia except: because he was Frederick II.[11] "
Interesting statement. That brings up the question, Why was Roosevelt so determined
to have war with Japan? The standard answer is war was declared upon Japan because they attacked Peal Harbor. But the attack upon Pearl Harbor was not the result of the Japanese being bored with themselves sitting around a Tea Table asking themselves how do we relieve our boredom?
Let's attack Pearl Harbor.
There were many attempts by the Japanese to comply practically of every demand of Roosevelt . Roosevelt wanted war with Japan
and if were not Pearl Harbor there would
have been another excuse for that war.
So why did we go to war with Japan?
Because Roosevelt was Roosevelt.
Published: February 17, 2008 10:17 PM