No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Four: Supply 89 goods for sale, the market price must exceed the subjectively assessed opportunity cost of all the productive resources used. Why? Because every resource used in production could have been used in some other productive activity and therefore carries an opportunity cost. If consumers signal to entrepreneurs (through the price system) that they value the output of a particular production process more than anything else the productive resources could have made, then supply will be forthcoming. Consider this scenario. Based on the sabotage of AirPods factories, you borrow $100,000 to build a small AirPods production facility that will allow you to produce AirPods for only $200, while they’re currently selling elsewhere for $1,000. Unfortunately, you need another $2,000 to complete the facility, with the additional $2,000 you will be able to produce 2 months after the initial production outage. But unbeknownst to you, after you obtained the initial $100,000 loan to build the facility, Apple was able to find a contractor to refurbish their facility in only two months by working three shifts a day. They’ll come back online at the same time as you and have promised a new lower price of $150 to reward customers for waiting for genuine Apple products. What do you do? When we put numbers in, the answer is fairly obvious. Apple will be able to produce AirPods for sale at $150, while you will have to charge $200. There is no reason to expect that you’ll get any sales—certainly nothing like your business model hoped and projected. Should you invest the additional $2,000 to go ahead and finish the facility? After all, you’ve already spent $100,000 and $2,000 is cheap compared to that! As a promising young economist, you will not be ensnared by the siren song of this common fallacy. You know that all decisions are marginal (or at least should be), and the only question to concern yourself with now is: if I invest the $2,000, what will be my return, and is it greater than my next best alternative? Given Apple’s early return to the market, my expected return is less than zero, as I’ll lose all the $2,000 and make no profit on top. (Let’s assume the capital investment in the facility is specific to AirPods only and at best will return scrap prices, effectively a total loss.) What about the $100,000 that is already spent? Does the decision not to spend the $2,000 effectively waste the $100,000 already spent? In short, NO! The $100,000 is wasted, but not by the failure to spend another $2,000—that would just be throwing good money after bad. The $100,000 was wasted once Apple came on line much earlier than anticipated. Your error in forecasting resulted in the misallocation of scarce resources, and the market will discipline you for this error. At this point, the $100,000 is a sunk cost , and is therefore irrelevant for future decision-making. In real life, this is very hard for most people to understand. Imagine the dreams you might have had in becoming a big AirPod producer. You may have become so emotionally entangled to that hope that failure to finish the facility, even if it is uneconomical, provides a psychic loss to you even greater than the economic loss. Many people will make uneconomic decisions based on this type of confusion. But as an aspiring economist, you know that sunk costs are irrelevant for economic decisions! Sunk cost: a past expenditure that cannot be recovered by any action taken in the present. Sunk costs are therefore not part of the decision calculus.