Sunk costs

Now lets talk about another factor in economics that we call sunk costs. These are costs that cannot be recovered once incurred. It is important to know that we shouldn't take them in consideration when we are making our decision.

For example a car. If we buy a car for lets say 1000$ (lets just say it's from FIAT), then we will be able to resell it, but at a much lower price (eg 500$). This means that the difference of 500$ are sunk costs. If we are considering buying that car, we shouldn't take in consideration that we will "loose" 500$ if we want to resell it in the future.

A good example and even a definition of these sunk costs is the so called "concorde fallacy". This refers to the fact that the French and British governement once continuted to fund an aircraft, that needed so much fuel, that even when no seats where left empty, it still wasn't economic. The price for the fuel was higher than they got back from the passengers for the tickets. But because the government thought it would be a commercial disaster to stop their flagship, they continued to fund it anyway.

Cost benefit analysis

The cost benefit analysis is an important keypoint in economics. In order to explain this to you as easy as possible, I will make another example on how this works. It's actually very easy and you probably already know what it's all about.


Sidejob:

• Earnings: 300$ per month
• You work 8 hours a week in an office
• Boring but not exhausting work

Let's say your parents come up for all your basic needs, but if you have extra wishes (like watching that awesome movie) you will have to pay for it yourself. A side job now has the benefit that you will have some extra money that you can spend how you want. On the other hand, you now have 8 hours less a week, these are your "costs".
In order to say if its a good idea to do the side job, we have to think about what you would have done in the mean time instead of working.

Let's say you would have studied. Since the work in the office is also not that exhausting, we can easily compare those two things. But: Since you have 8 hours less each week to study, there is a reasonable chance that your studies will extend for 1 year.

This means that in the meantime you will earn 4x12x300 = 14.400$ in those 4 years of studying and working in the office. But on the other hand you could have earned easily 25.000-30.000$ in the fourth year if you would have finished your studies in 3 years.

This means that the salary of this lost 4th year counts as costs. Costs that come up because you didn't take an alternative are called alternative costs / opportunity costs.

Also, we need to take in consideration the costs that will occur for others:

• Depending where you study, the state has to pay for your studies for another year
• Your parents will have to come up for your living for another year

Now I am not saying that you shouldnt work during your studies. But if you get the opportunity to do something that is interesting or even has to do with your studies, do that. You might build up useful relationships and get an idea of what you will be doing after university.

Willingness to pay

Let's start off with a very simple example for a typical consumer decision. This will show you the principle of the "willingness to pay", which is part of the basics for economics.

A consumers decision:

Example 1:
Its a rainy day and a friend of yours invited you to go to the cinema with him. The ticket costs exactly 10$.

Question: Should you go to the cinema?

Well we cant answer that question just yet. In order to do that, we need to know what your alternative for that day would be. So our question is never "Should I do this?" but rather "Should i do this or that?"

Now the easiest alternative to going to the cinema would be to stay at home and do nothing. But we still can't answer that question if we don't know how high is your personal gain from going to the cinema (or staying at home).

Thats where our first keypoint in economics comes in:

Willingness to pay:

Lets say you would be willing to pay 20$ to go to the cinema (because you are going to watch the "Dark Knight Rises" and that movie is freaking awesome). That means if the ticket would actually cost 20$ you would be indifferent. This means:

• If the ticket costs more than 20$ you would stay at home
• If the ticket costs less than 20$ you would go on an epic adventure with Batman

So lets give this idea some kind of a formula:

• WPA is the willingness  to pay for the ticket (20$)
• GA is the personal gain for going to the cinema and CA  is the cost for the ticket
• GB is the personal gain from staying at home and CB the correspondent costs (GB = 0 and CB = 0) 

This means you will go to the cinema if GA - CA > GB - CB and you would stay at home if GA - CA < GB - CB. You would be indifferent in case if GA - CA = GB - CB.

This means your willingness to pay is:

WPA = GA - GB + CB

 

So if your best alternative would be to stay at home, you should go to the cinema as long as the ticket costs less than 20$. But what if there is a better alternative than staying at home? Now I will show you an alternative with different costs/benefits.

Example 1:
If you don't go to the cinema, you could go eat some ice cream.

• One ice cream costs exactly 1$ so the Ci = 1$
• You would be willing to pay about WPi = 10$ for eating ice cream, rather than staying at home doing nothing at all
• This means your personal gain from eating ice cream is Gi = WPi = 10$
• So you will go to the cinema as long as GA - CA > Gi - Ci
• Since 20 - 10 > 10 - 1 you should go to the cinema

Introduction to economics

Welcome to my  new blog about the principles of economics!

As a student you might already encountered a very simple yet interesting question, when you were looking for an apartment near your university.

Why are these apartments so expensive?

Economists will now start to ask themselves different questions:

• What is the reason for these prices?
• Are they fair?
• How could we change them, if we wanted to?

In order to answer these questions, we will need to cover 3 basic problems:

1. Consumer decision: How do individual consumers behave (eg. when looking for an apartment) and how can you calculate the demand.
2. Production decision: How do individual producers (eg. apartment supplier) behave and how can you calculate the supply.
3. The market: What happens if demand and supply encounter? What will the prices be?

The reason economics exists is shortage. Because if one resource is used up, someone else won't be able to get it. That is why all our economic decisions are based on comparisons.

• Should I live in an apartment or at home?
• If I have to pay such a high rent, how much of my money will be left for other things?

Thats why we need to compare our costs to the benefits.


Here are a few keypoints that we will go through within the next lessons:

• Willingness to pay
• Opportunity costs
• Cost benefit analysis
• Sunk costs
• Marginal analysis