Marginal Thinking and the Sunk Cost Fallacy

♪ [music] ♪

In economics,

you're likely to hear
the word "marginal" a lot:

marginal benefit,

marginal cost,

marginal revenue--

the list goes on and on.

So what is thinking on the margin,

and why is it important?

Marginal just means
a little bit more

or a little bit less.

Let's imagine
that you're watching a movie,

and you can't hear the dialogue.

You increase the volume
just a little bit.

How high should you go?

Well, that's a question
of comparing the marginal benefit

to the marginal cost
of increasing the volume.

The first notch up sounds good.

Now you can hear
what the actors are saying.

You increase it another notch.

Speakers are distorting a little,
but you still prefer it.

One more notch.

Uh-oh!

Now there's an action scene.

It's too loud!

You don't want to wake up
your roommates.

So you decrease it a notch.

You keep doing this,

making marginal adjustments
up and down,

comparing the marginal benefit
to the marginal cost,

each step of the way.

Thinking on the margin

just means comparing the benefit
of the next decision to its cost.

Notice that thinking
on the margin --

it's a method or way of arriving
at an optimal or best decision.

If I asked you for the best volume
to watch a movie,

you might have trouble answering.

But if you keep thinking
and acting on the margin,

you'll come to a point

where the marginal benefits
equal the marginal costs --

that's the optimum.

So thinking on the margin

is a way of searching for
and finding an answer

to a problem that might otherwise
be quite difficult.

Thinking on the margin

also tells you something else
of importance:

what not to think about.

Let's imagine you run
a small clothing shop,

and you think that the 1970s
are about to have a renaissance.

I remember those times!

♪ [music] ♪

So you load up on 100 pairs
of bell-bottom jeans.

Let's say you paid $75 a pair.

You price the jeans at $100 --

a price that will cover your costs,
including rent and wages.

But unfortunately, the jeans --
they just don't sell.

What do you do?

You think about lowering the price,

but your accountant tells you

that if you lower the price
below $100,

you're guaranteed to take a loss.

(scream sound)

Fortunately, you had
a good Economics class

in high school or college,

so you remember
that what you paid for the jeans

is irrelevant.

That cost is sunk.

What matters now

is to compare the marginal benefits

and marginal costs of your options.

One option would be to put
the jeans in storage and hope --

hope they'll come back in style.

Maybe you can get $100
per pair in the future,

but you get no money now,

plus you have to pay for storage.

Another option is to slash prices.

Sell them all now for $50 each.

That lets you clear out
your inventory

and invest in something else.

You choose option two

and invest in the next big thing:

leg warmers!

Now, I know this sounds simple,

but actually, even experienced
business people --

they often focus too much
on what they paid for an item

and not enough
on their best choices right now.

It's called the sunk cost
or fixed cost fallacy.

In fact, I snuck an example
of the fallacy right past you.

Did you catch it?

Earlier, I said you price
the jeans at $100 --

a price that will cover your costs,
including rent and wages.

But that's also wrong.

If bell-bottom jeans turn out to
be in huge demand, for example,

then you should price
them for more than $100.

What you paid for the jeans is irrelevant,

whether your decision was
a bad one or a good one.

People fall prey to this
kind of error all the time,

especially holding on to past mistakes.

Maybe you've been told, never give up.
Well, take the advice of an economist.

Sometimes giving up is
the smart thing to do.

Is the movie you're watching boring? Well,
buying the ticket was a bad decision.

But that cost is sunk. Don't
throw good time after bad.

Walk out! No one likes to admit
that they made a bad decision.

And so they stay in bad relationships,
bad businesses, and bad careers,

hoping, hoping to turn things around

and prove that their past
decisions weren't so bad after all.

An economist says, ignore what
you can't change. Ignore the past.

Focus on the future. Let's
summarize thinking on the margin.

First, think about a little
bit more or a little bit less,

and keep going until you arrive at a point

where the marginal benefits equal the
marginal costs. That's the optimum.

Second, when making a choice,

only think about the costs and
benefits that change with that choice.

Ignore sunk costs.

Thinking on the margin, it's useful,
and not just for economics classes.

But if you are teaching
an economics class,

check out our free unit plan
that incorporates this video.

I promise, the marginal benefit
will exceed the marginal cost.

And if you're ready to test yourself,
check out our practice questions.

Finally, if you're ready for more
microeconomics, Click for the next video.