Tatyana Deryugina (Twitter: @TDeryugina)

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Sunk costs in the real world

Posted 05 Mar 16 by arbelos

Most people are taught in introductory economics courses that they should ignore "sunk costs" (costs that cannot be recovered) in their introductory economics courses. But sometimes decisions involving sunk costs can be tricky, as a recent example I came across illustrates.

I have a "friend" who booked a spring break trip to the Dominican Republic with her two kids and husband nine months in advance. About two weeks before they were scheduled to leave, she realized they didn't have a passport for their younger son. They didn't forget, they didn't procrastinate, they didn't think he DIDN'T need a passport (their older daughter had one) - they just didn't think about it. It's one of those inexplicable things like a woman who doesn't realize she's pregnant until she goes into labor. On top of that, American changed their flight itinerary in a way that would make them have to spend a night in Chicago on the way there and probably on the way back. So they were not happy.

As it turned out, it was possible to get a passport on such short notice, but it would involve driving to Chicago (which is 2.5 hours away) during a work day with the son. But the question is, should they do that? Or should they cancel their vacation and stay home? Unsurprisingly, the answer depends on whether or not the airfare and hotel are refundable.

If the trip is not refundable (= sunk cost), it should make my friend MORE likely to go on this vacation than if it's refundable. Why? Because then the (marginal) cost of the nice vacation becomes the time and effort to drive to Chicago, the two nights' hotel stay in Chicago, and the unpleasantness of dealing with all that. That's not too bad for a fancy week-long vacation in the Dominican Republic. On the other hand, if the trip is fully refundable, then you have the costs already listed PLUS the money paid for the trip (because you could get the money back, it's as though it's still sitting in your bank account and you're considering whether to buy the trip). And while my friend was willing to buy the trip when the flights were easier and the document issue was not on her mind, adding these things into the mix tipped the balance against the trip.

As it turns out, the trip was almost fully refundable, so the family decided to cancel the trip. The moral of the story is that whether or not a cost is sunk changes the marginal cost of doing something and you should consider that next time you forget that you need a passport to go to Canada and find yourself without one.

And I'll be staying in Champaign over spring break...

 


Views : 1025 | Tags: sunk cost, economics
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