Opportunity Cost and Sunk Cost
Opportunity cost: Example 1
 1st Scenario:
 Your friend says that on Saturday you should go to the beach. A day at the beach
is worth to you 60 TL, the cost of food, transportation and entrance fee is 30
TL. On Saturday your initial plan was to work as an RA in the lab which pays
40 TL. You like the RA job so you would do it for free.
 If you are rational, will you go to the beach?
Opportunity cost: Example 1 (cont’d)
 1st Scenario:
 Your friend says that on Saturday you should go to the beach. A day at
the beach is worth to you 60 TL, the cost of food, transportation and
entrance fee is 30 TL. On Saturday your initial plan was to work as an
RA in the lab which pays 40 TL. You like the RA job so you would do it
for free.
 If you are rational, will you go to the beach?
 Answer : NO. Cost = 30 + 40 (if you go, then you give up the
opportunity to spend 30 TL for something else and also to earn 40 TL in
the LAB.)
 Cost =70 > Benefit = 60
Opportunity cost: Example 1 (cont’d)
 2nd Scenario:
 Your friend says that on Saturday you should go to the beach. A day at the beach
is worth to you 60 TL, the cost of food, transportation and entrance fee is 30
TL. On Saturday your initial plan was to wash dirty dishes at the yemekçi
cafeteria. This job also pays 40 TL. BUT you don’t like it and you would not do
it for less than 20 TL.
 If you are rational, will you go to the beach?
Opportunity cost: Example 1 (cont’d)
 2nd Scenario:
 Your friend says that on Saturday you should go to the beach. A day at
the beach is worth to you 60 TL, the cost of food, transportation and
entrance fee is 30 TL. On Saturday your initial plan was to wash dirty
dishes at the yemekçi cafeteria. This job also pays 40 TL. BUT you don’t
like it and you would not do it for less than 20 TL.
 If you are rational, will you go to the beach?
 Answer : YES. Cost = 30 + (40 – 20) (if you go, then you give up the
opportunity to spend 30 TL for something else and also to obtain a benefit for
40 – 20 = 20 TL from the job at the cafeteria.)
 Cost =50 < Benefit = 60
Opportunity Cost
 The opportunity cost is the value of the next best alternative
when one makes a choice.
◦ The cost of an education is:
 Tuition
 Books
 Travel expenses
 Lost earnings from not working for four years
Opportunity cost: Example 2
You won a free ticket to see an Eric Clapton concert (which has no resale
value).
Bob Dylan is performing on the same night and is your next-best
alternative activity. Tickets to see Dylan cost $40.
On any given day, you would be willing to pay up to $50 to see Dylan.
There are no other costs of seeing either performer.
Question : What is the opportunity cost of seeing Eric Clapton?
A) $0
B) $10
C) $40
D) $50
Opportunity cost: Example 2 (cont’d)
 When you go to the Clapton concert
 you forgo the $50 of benefits
 you also forgo the $40 of costs
 Opportunity cost of seeing Clapton is the net benefit you
forgo by not going to the Dylan concert
 Correct answer is $10
Opportunity cost: Example 2 (cont’d)
 Ferraro and Taylor (2005) asked this question to PhD students and
faculty in ASSA meetings in 2005
http://epp.gsu.edu/pferraro/docs/ferrarotaylorbep.pdf
Here are the answers:
Answer Ratio
$0
25.1%
$ 10
21.6%
$ 40
25.6%
$ 50
27.6%
 Worst were Macro (14.3%) and Business Economists (15.4%)
Best were Micro-economists (42.9%)
Opportunity cost: Example 2 (cont’d)
 Here are your answers:
Answer
@ 9:30
Section
(Out of 53)
Ratio
@ 11:00
Section
(Out of 64)
Ratio
$0
8
15 %
10
15 %
$ 10
26
50 %
24
38 %
$ 40
11
20 %
18
28 %
$ 50
8
15 %
12
19 %
 Worst were Macro (14.3%) and Business Economists (15.4%)
Best were Micro-economists (42.9%)
Sunk Cost: Example 1
 Taken from an interview with Prof Robert Frank published at the Challenge
magazine in June 2008.
Q. Explain that a little more.
A. [Richard] Thaler was doing “rational choice with regret.” He would find that
people just made mistakes, and when he would point it out, they would say,
“Oh, yeah, I screwed up; I would like to change my decision. One
experiment he conducted was at a Pizza Hut, which had a deal: Pay $3 at the
door, and eat as much pizza as you want for lunch. So he had a research
assistant pose as a waiter, who returned $3 to half the patrons at random. He
told them that they had been selected for a promotional special, so their
lunch that day was on the house. Then he kept track of how much pizza was
consumed by the two groups.
Sunk cost: Example 1 (cont’d)
Q. And what happened?
A. Rationally, the extra or marginal cost of eating another slice is zero under the allyou-can-eat plan.You have already paid your $3. For those who got their money
back, the cost of eating another slice is also zero. The rational choice for both
groups is to keep eating until you get no additional utility from the next slice. So
the prediction of the rational choice model is that the two groups would eat the
same amount of pizza. But as any ordinary human being can guess, the people who
got their money back did not eat nearly as much as the people who did not.
Q. So the people who paid ate more.
A. They ate a lot more. They seemed to be trying to get their money’s worth.
Q. That is the sunk-cost fallacy.
A. The fact that they had incurred a sunk cost should be irrelevant in a rational decision
about how much pizza to eat. And after they left many of them surely regretted how
much pizza they had consumed.
Sunk Cost: Example 2
 Taken from “Why smart people make major money mistakes. Mental blind spots can
lead you into financial blunders. Here's how to think clearly about money.”
MONEY magazine, by GARY BELSKY REPORTER ASSOCIATE: JEANHEE KIM
LESLEY ALDERMAN; july 1, 1995
http://money.cnn.com/magazines/moneymag/moneymag_archive/1995/07/01/
204202/index.htm
 You've been given a free ticket to an exciting football game. At the last minute, a
sudden snowstorm makes getting to the stadium somewhat dangerous. Would you
go?
 Now, assume the same game and snowstorm, except this time you paid handsomely
for the ticket. Would you go?
Sunk Cost: Example 2 (cont’d)
 Most people are more likely to risk their safety in the snowstorm if they paid for the
ticket, according to Richard Thaler. But from a strictly economic point of view, that's
irrational. In both scenarios, the choice is the same -- to use the ticket or not.
 Two all too human tendencies come into play here. The first is sometimes called the
sunk-cost fallacy, meaning that having paid for an item or service can make us
overly reluctant to waste it. In the case of the football game, a person who paid for
the ticket is more likely to view missing the game as a "waste" than the person who
was given the ticket. That's irrational, explains Thaler, because "the fact that you
spent $100 shouldn't matter when you decide between the reward of seeing the
game and the risk of getting killed."
Sunk Cost: Example 3
 Question:You bought a ticket for a movie for 15 TL. The benefit you get from seeing
the movie is 20 TL. Just before the movie, you realized that you lost the ticket.
Would you buy a new ticket or not?
Sunk Cost: Example 3 (cont’d)
 Question:You bought a ticket for a movie for 15 TL. The benefit you get from seeing
the movie is 20 TL. Just before the movie, you realized that you lost the ticket.
Would you buy a new ticket or not?
 Answer:Yes (Sunk-cost fallacy)
Sunk Cost: Other Examples
 How long would you watch a bad movie?
 Bad food from a restaurant
 All-inclusive hotels