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Posts Tagged ‘business

Microeconomic Life Lessons: Sunk Cost

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Imagine: My friends and I are at an all-you-can-eat Japanese restaurant celebrating a tournament win. We are stuffed to capacity and cringe at the thought of putting another piece of food in our mouths. An uneaten roll taunts us from the table. The sushi can’t be wrapped up and taken home. We do what the average American would do -the ladies are spared as the big guys at the table eat themselves to near-sickness. Their argument for eating the last roll is that they would not get the full value of their initial payment if they didn’t. To my surprise – they finish the roll on the table and order a few more. Then dessert. Then someone throws up.

This episode occurred before I took my first economics course. An understanding of sunk cost may have helped our over-eaters make better decisions.

Wikipedia entry on sunk cost:

In economics and in business decision-making, sunk costs are costs that have been incurred and which cannot be recovered to any significant degree…Economics proposes that a rational actor does not let sunk costs influence one’s decisions, because doing so would not be assessing a decision exclusively on its own merits….For example, when one pre-orders a non-refundable movie ticket, the price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back the money he originally paid.

When we saw the roll on the dinner table we had two options:

1. Eat the roll – causing discomfort.

2. Let the roll go (and learn not to waste food in the future by ordering smaller portions).

No matter which option is chosen – we have already incurred the cost of the meal. Therefore, the information about the price we have already paid is irrelevant. A rational actor would choose the option that provides the greatest happiness (utility). In our case, leaving the roll on the table with a big tip and going home with a “I just ate sushi” glow on our faces, would have been a much better alternative to leaving an even bigger tip after a watching friend throw up in a restaurant.

I’ve been taught never to waste anything (especially food) – I’ve been known to use questionable bread for French Toast, pick brown pieces of lettuce off out of the bag, and prefer information from a “smell test” to to written expiration dates. My knowledge of sunk costs has helped me realize that I should buy less and order smaller portion sizes to avoid these situations altogether. Sunk costs should be barriers to entry – people should think about costs that cannot be recovered no matter what course of action is taken and factor that into their decision-making. In situations where I have to make the choice to suffer or let it go – I’ve learned to just let it go.

This concept can be applied to other situations:

– Choosing whether or not to go to a lame party after you’ve bought the non-refundable tickets and attire.

– Deciding to downgrade to Windows XP after buying Vista (I offer my sympathy to Windows users who have to make these tough decisions…).

– Exiting the Iraq War

Written by TeacherC

16 June 2008 at 2:39 pm

Microeconomic Life Lessons: The Second-Mover Advantage

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My nephew (age 12) had an existential crisis the other day. He wants to be a musician or a writer but is stressed out because “all of the good ideas are already taken”.  I decided to spare him four years of rigorous economics coursework and told him about the most important economics lesson I’ve learned – the second-mover advantage:

Second-mover advantage occurs when a firm who follows the lead of the first-mover is actually able to capture greater market share, despite having entered late.

First-mover firms often face high research and development costs and the marketing costs necessary to educate the public about a new type of product. A second-mover firm can learn from the experiences of the first mover firm and may not face such high research and development costs if they are able create their own similar product using existing technology. A second-mover firm also does not face the marketing task of having to educate the public about the new project because the first mover has already done so. As a result, the second-mover can use its resources to focus on making a superior product or out-marketing the first mover…the notion that winners are always the first to enter the market is a misconception. (Wikipedia entry)

Examples include Obama (vs. Hillary), Nintendo (vs. Atari), Oprah (vs. Donahue), and AMD (vs. Intel). Second-movers are able to capitalize on the work done by others and create innovative products at a lower cost. The “early bird may catch the worm” but later birds can dominate marketing and distribution.

Think different? No: Observe first. Think second.

Written by TeacherC

11 June 2008 at 2:12 pm

Big lenders drop community college students from rolls

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Our economic crisis is disproportionately hurting lower-class citizens. Big lenders have cut off loan services for students of community colleges and less-selective four year colleges (NYT article here). Over 40% of college students attend these institutions. These institutions of higher education are often the bridge between the lower and middle class – they offer innovative professional tracks, serve students who do not fit into traditional educational settings (including students with disabilities, parents/caretakers, and gifted students) and provide many other important services to communities. In recent years, states have looked toward community colleges to shortages in the fields of nursing, teaching, transportation technology, air traffic control, and many other careers.

Cutting off funding opportunities for students who attend these institutions destroys another path toward economic mobility for millions. Moreover, there are may be a ripple effect felt in critical sectors of the economy.

What’s the solution? For the time being, students are able to find fallback loans with higher rates and less perks (ex – no more rate cuts for students who pay loans on time). Also, students who are not able to get as many loans as before have to assume credit card debt and/or work extra part-time jobs. This makes students less-likely to finish school or decreases their earnings once they leave college.

One solution, is to have professional organizations, nonprofits, and state/federal governments promise students repayment of loans if they finish school and take jobs in critical areas. This solution would be a band-aid for issues of equity and access that ripple throughout our education system. Lenders are dividing schools into a tiered system because they see the difference in earnings potential between ‘elite’ and ‘non-elite’ students.

Sadly Relevant/Cheesy Poster: