Traditional microeconomics teaches us that we should make decisions on the margin. That is, we should ignore sunk costs. Sunk costs are costs we have already been incurred and cannot be recovered regardless of your next time. In order to optimize revenue, theory of the firm states that, in perfect competition, marginal revenue should be equal to marginal cost. That is, how much you earn for selling the last unit of a product should be how much it costs you to produce that product (in this perfect world, that would also be the price on every unit). This also applies for people and their utility. You should assess both costs and benefits on the margin, in the next time period, on the next purchase, without thinking of everything that came before.
Logic In, Emotions Out.
Most of us, of course, don’t do this. How many times have you sat through a movie you hated because you paid for the ticket already? How many times have you waited for the subway an extra 20 minutes instead of just walking because you have already waited for 20 minutes? And how many times you have eaten that last slice of pie even though you were really incredibly full because you already heated up the whole thing and you didn’t want to throw it away? Enough times, I am sure, that you are aware of the phenomenon of, at the end of the movie, wait, or pie, being incredibly bored, late, or nauseous, and wondering why you just did that.
The reason you just did whatever irrational behavior it was that I just described (or a host of others) is that, unfortunately, you’re human. And that, as always, is the lesson from behavioral economics. Humans aren’t irrational! So why treat them that way? Now we come back to our good friend prospect theory, which was mentioned in the first article I wrote about behavioral economics. In addition to valuable insights on reference points, prospect theory states that people are inherently loss averse. Not only that, but they did to weigh losses twice as heavily as gains — that is, a loss of $1 is twice as painful as a gain of $1. The combination of a non-neutral reference point and loss aversion is what leads to irrational behavior.
Once you have decided to see the movie, wait for the subway, or eat that piece of pie, your reference point account for your doing those things. That is your neutral position. Not achieving these goals is a loss. This sort of mental accounting, as it is called, commits you to decisions that are less than ideal.
A good businessman, either online in a serious game such as The CEO Game or in real life, doesn’t let a misplaced sense of regret and loss stop him from making proper economic decisions. Recognize when you’re including sunk costs in your decision-making and put an end to it. Live life on the edge, or margin. You’ll be happier, and wealthier, for it.
The CEO Game.