Opportunity cost, and sunk cost are two terms from economics that have become an accepted part of the mainstream vocabulary. Generally speaking, most people understand what each means, but what the economic underpinning of both terms? Understaning both of these of costs and how they should or should not apply to our decision making leads to better financial decisions.

Opportunity Cost
The concept of opportunity cost underpins much of what is considered microeconomics. It’s one of the most important concepts there is. Opportunity cost is the cost incurred by doing something because it removes the option of doing something else. The best example and simplest understood example of opportunity cost is how it applies to education. For instance if I were to choose to attend graduate school for y dollars, the cost is not only y dollars, but also x dollars in forgone salary. Opportunity costs apply to any situation in which there is any kind of choice. The cost may be monetary, or it could be just as likely time or experiential. When we pick entree from a menu we experience both accounting and opportunity cost acutely. The accounting cost is the price of the entree, and the opportunity cost is not having being able to eat the next best dish (assuming that we can only eat one entree). The opportunity cost is not opportunity of eating all the items on the menu, only the best alternative. An economically minded person understands that the true economic cost of deciding upon one specific entree is both the price of the entree and foregone experience of eating the other dish. Thinking about opportunity costs leads to better decision making.

Sunk Cost
Sunk concept is in some ways the mental flip side of opportunity cost. Whereas we often forget or ignore opportunity cost to our detriment, we don’t ignore sunk costs when we should. Sunk costs are the cost already incurred that cannot be recouped. Sunk costs do not represent any value, they purely represent the money, time and effort already put into a cause. Keeping sunk costs in mind generally leads to good money being thrown after bad. Another example of sunk costs can be seen in the commercials supporting the war in Iraq. While I personally don’t agree with the current war, I believe it’s perfectly rational to disagree with me on that point. However, my inner economist cringes at the one commercial I’ve seen which features a brave veteran who lost his legs in Iraq. The commercial ends by saying something like, “don’t let my sacrifice be made in vain.” Any reasonable economist understands rational decisions going forward should not be based on costs incurred in the past, sunk costs. These commercials are effectively pitching the consideration of sunk cost. The pitch to economist must be made on the benefits outweighing the cost going forward. If an economist were directing the commercial, the pitch would identify the opportunity cost of staying Iraq vs leaving which are innumerable - stability in the middle east, lower terrorism, increase American credibility, etc. Regardless of where one stands on the issue, arguments should at least be made on sound and rational thinking. Consideration of sunk costs is irrational.

The more common (and much less political) example of sunk cost is the cost of a movie ticket. Once the the ticket has been paid for it’s a sunk cost, and should not be heeded in the decision to actually watch a movie. So if you’re watching a movie, and it’s bad there’s little reason for you to stay. The price of the ticket is sunk, and staying and watching the movie has an opportunity cost of watching another movie or doing something else. If watching the movie is not producing value, the cost of watching (the opportunity cost) should be the only consideration and not the fact that one’s already paid $10 for a ticket. Yet, how many of us will continue watching a bad movie? Or even worse, stay in a investment because of what we’ve already paid?