Marginal Thinking and the Sunk Cost Fallacy

Thinking on the margin is one of the most fundamental concepts in economics–and a valuable everyday tool for making optimal decisions.

For such an important idea, the meaning of marginal thinking is surprisingly simple: when faced with a decision, you should compare the marginal benefit of a possible action to its marginal cost. If the marginal benefit is greater than the marginal cost, do it!

Marginal thinking is best illustrated by some examples of everyday decisions. The volume you choose when you watch TV, the pricing strategy of a clothing shop, or even the decision to walk out of a boring film are all informed by marginal thinking.

The “Sunk Cost Fallacy” is a common failure to apply marginal thinking. Focusing on past decisions–the price we paid for an item, the time we’ve already invested in a relationship–can lead us astray. We can’t change the past, so only the potential marginal benefit and marginal cost of the next possible action are relevant to decision-making.

Get our FREE Intro to Economics unit plan: https://mru.io/y7r
Continue learning with practice questions: https://mru.io/8ya
Watch the next video: https://mru.io/0my

♪ [music] ♪

- [Alex] 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.

[voices coming from movie]

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.

[slightly louder voices]

You increase it another notch.

[louder voices]

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

[louder voices]

One more notch.

[loud explosion]

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.

[quieter voices]

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.

- [Funny voice] What?
- 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 effect]

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
businesspeople --

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'll 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.

♪ [music] ♪