Are You Making the Right Decision? The Economics of Opportunity and Sunk Costs

A couple of weeks ago, I posted my first LinkedIn poll: “You spend $1,000 on a concert ticket. The day before the event, you notice that the resale value of your ticket is $10,000. Which answer is true”:

• You spent $0 if you attend

• You spent $1,000 if you attend

• You spent $10,000 if you attend

• You spent $9,000 if you attend

While the second option got the most votes (68%), each of these answers got at least some votes. What is it about this seemingly simple question that is getting people to answer so differently? It all comes down to how people define “cost” and “spending”. More specifically, this question touches on two concepts from economics: opportunity cost, and sunk cost.

Opportunity Cost

Have you ever been scheduled for a work shift and then asked a coworker to cover for you so you could attend an event you wanted to go to, such as a restaurant outing with close friends? Let’s assume that the food would end up costing you $100 (you ordered a medium rare Chicago style rib steak). If we do not take opportunity cost into account, the cost of going is simple: it cost you $100. If we do consider the opportunity cost, this night out cost you $100 plus the income you would have earned if you worked your shift that night (let’s say $150), for a total cost of $250.

By solely looking at your bank account, you would only see a decrease of $100, which is why it would be misleading to think that it only cost you that amount. On the other hand, by not going, you might miss out on the experience of spending time with friends, which might be worth more than the $250 you’re “spending” by choosing to go out.

Sunk Cost

The other concept we need to define is sunk cost. Let’s say you’re planning a trip to Italy and you purchase a $100 ticket to visit a museum on a specific day. When you arrive at FCO (Rome’s airport), you notice that the weather forecast shows that the only sunny day of your trip is the same day you planned to visit the museum indoors... Now, you face a decision: should you visit the museum or seize the sunny day to enjoy Italy’s beautiful weather?

Here’s the main point: the $100 you spent on the museum ticket is a sunk cost. It’s already gone and cannot be refunded, no matter what decision you make. Therefore, the amount you paid should not influence your choice. If you’d rather enjoy the sunny day, then that should be your focus, because the money spent on the ticket is gone either way. if you decide to go to the museum simply because you paid for it knowing that it is the option that brings less happiness, you’re making an irrational decision. In that case, you’re choosing the outcome that makes you less happy, even though both options (museum or sunny day) cost you the same amount in the end. The goal should be to maximize your happiness (short and long term) and make decisions that reflect that, without being influenced by sunk cost.

On the other hand, one could argue that attending the museum might bring satisfaction simply because you're making use of something you already paid for. For some, the thought of not utilizing something they've spent money on can trigger negative feelings, making attending the museum feel like the better option, even if it's not the choice that maximizes overall happiness.

Concert Ticket Example

Now, let’s go back to the poll at hand: how much does the concert cost you if you decide to attend it knowing that it’s valued at $10,000. It’s important to position ourselves at the time where you’ve already purchased the ticket (non-refundable), and you’re making the decision to either (1) attend the concert, or (2) sell it for $10,000. Let's examine each answer and demonstrate how a case can be made to support the validity of each statement.

You spent $0 if you attend: Since you already paid for the $1,000 (sunk cost), it’s costing you nothing to go to the concert.

You spent $1,000 if you attend: You paid $1,000 for the concert, and you attend, so it simply cost $1,000 (not considering sunk or opportunity costs).

You spent $10,000 if you attend: You have an opportunity to attend which would cost you $0 since the cost is sunk, or to sell the ticket and make $10,000 (opportunity). So attending is synonymous with spending $10,000.

A renowned data-scientist commented on my post suggesting that $9,000 could be the answer. This could make sense from a net-worth perspective, since selling the ticket would effectively increase you’re net worth by $9,000 (spend $1,000 to purchase the ticket, and earn $10,000 by selling it).

Conclusion

So, why does this seemingly simple question spark such varied answers? The key takeaway is that our understanding of costs, and how we make decisions, is deeper than just the money spent. By considering opportunity cost and sunk costs, we gain a more nuanced perspective that can change the way we approach not only financial decisions but everyday choices as well.

Think about how these concepts can influence your decision-making in areas like investing, career choices, or even personal relationships. For example, when holding on to a losing investment, many people fall into the trap of “I’ve already lost this much, so I’ll hold on until it recovers”, without considering whether it’s the best use of their resources now, today. Understanding that past decisions (sunk costs) shouldn’t influence present ones can allow you to make choices that truly align with your short and long term goals.

In the end, making use of concepts like opportunity cost and sunk cost can help us make decisions that will bring us closer to our long-term happiness, goals, and success. So the next time you’re faced with a decision, ask yourself: “What’s the real cost here?”. You might find that a seemingly simple choice has more to it, and that awareness could lead to a more thoughtful, informed decision.