by Andrea Magnusson
In my first year of university, I was walking to uni one morning, and I’d gotten some way down the hill before I realised that I had forgotten my umbrella. Checking the forecast showed that there was a chance of rain later in the day, and it would be such a shame having to trudge uphill in the damp.
What faced me then was a decision: to go back up the hill and retrieve my umbrella, or to take the chance and continue on to uni.
Now the first thought that came to my mind was of course, “well I’ve already come all this way, there’s no point in going back now”. It was while pondering this thought that a revelation struck me.
That was a sunk cost.
There was no merit in thinking about how far I had come while making my decision to go back. All I needed to do was consider the costs and benefits of actually going back now, since regardless of the choice I made, the time I had spent getting down the hill so far would not come back.
With that in mind, I happily headed back up the hill to fetch my umbrella, rather pleased at having applied some new economic skills, ones that I had only learned in class just a few weeks prior. I didn’t even end up needing the umbrella later on, but I was so pleased with my economic decision-making that it didn’t matter.
This story highlights the fact that economic decision-making skills can be used in everyday life. Today, economics is increasingly abstracted from reality, with its long lists of assumptions, and mathematical models that can’t really be applied to real people. But this doesn’t mean that economic theory can’t be useful for anything other than getting good marks at uni.
Now of course, many economists will argue that people always use economic thinking in everyday life, in their choices to save money, invest, purchase, and work. And while this may be true on an aggregate level, as an individual, you aren’t necessarily going to think rationally, or in a particularly economic manner when making these decisions. What I’m talking about here, is instead consciously taking note of economic concepts, and using them in everyday decision-making. In the example above, I consciously thought about the concept of sunk costs, and used that to improve my decision-making. This can be done with a range of economic concepts, each of which can help better understand everyday decisions.
One important concept to take into account while making decisions is that of opportunity costs. To demonstrate, imagine that your parents have invited you to dinner, and they’ve offered to pay. Should you go? For most, the answer will be yes, but it can be helpful to think about why. Is it because the dinner is free? In absolute monetary terms, it might be, but this doesn’t mean there’s no cost. In attending the dinner, you’re giving up your time, which could be spent doing something else, such as studying. In making this decision, or any other decision, it’s helpful to consider non-monetary costs. And this can easily be applied to simple, everyday decisions, such as whether or not to walk to uni, or whether to attend an event.
Something else to consider is the idea of diminishing marginal returns. Lots of us love chocolate, but we only eat a little at a time. Why is that? Well, while the first, second, and third chocolates are delicious, the 100th one tends to make us feel sick. This is because each additional chocolate we eat gives us just a little less benefit than the one before. Familiarity breeds contempt, after all. Now it’s all well and good to say that good things have diminishing marginal returns, but how can this be applied in the everyday? To use the chocolate example, you might be deciding whether to eat a second one now, or save it for tomorrow. In making that decision, you could consider that right now, the second chocolate won’t bring you as much benefit as the one you already ate. In saying that, it might be best to save it for tomorrow – you might enjoy it all the more.
But, you might say, you’re an impatient person, and it’s hard to wait for the supposedly increased benefit of eating the chocolate tomorrow. That’s where the concept of discounting comes into play. In economics and finance, discounting is used to account for the fact that people tend to prefer things now, rather than wait for them. That is to say, future benefits are worth less than those received today. This is a useful concept to understand, as it may help you understand why you make certain decisions when considering putting things off. This understanding could allow for better decisions – your future self will thank you!
Many of these concepts are very basic in terms of economics, and they’re not necessarily going to revolutionise your daily life. However, they can be useful to be conscious of, so as to better understand the decision-making of yourself and others, and hopefully make better decisions too. And who knows? If we all start using these skills in our everyday lives, it might just make those abstract economic models a little closer to reality.
TUBES Publications are a collection of interviews, guides, and articles on all things Business & Economics. Sign up for our newsletter, where you'll get regular updates for all future TUBES publications.