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Explanations

In Economics - what is thinking at the margin?

Graham Watson

2nd August 2023

A typically excellent Marginal Revolution University clip looking at one of the most basic economic principles, the marginal principle, which is an essential part of thinking like an economist. This then segues into a consideration of the 'sunk cost fallacy' applying the marginal principle - showing how people can fall foul of it when running a business.

Thinking at the margin, in economics, refers to the process of making decisions by considering the incremental or additional changes that result from a small, incremental change in a variable. This concept is fundamental to understanding how individuals, firms, and governments make choices and allocate resources.

When thinking at the margin, individuals and decision-makers assess the costs and benefits of producing or consuming one more unit of a good or service. In other words, they evaluate the trade-offs of increasing or decreasing their current level of activity by a small amount.

Key points to understand about thinking at the margin include:

  1. Marginal Benefit (MB): This refers to the additional benefit gained from producing or consuming one more unit of a good or service. It's the positive impact of the incremental change.
  2. Marginal Cost (MC): This represents the additional cost incurred from producing or consuming one more unit of a good or service. It's the negative impact of the incremental change.
  3. Comparing Marginal Benefit and Marginal Cost: Rational decision-making occurs when individuals or entities compare the marginal benefit with the marginal cost. If the marginal benefit is greater than or equal to the marginal cost, it is generally considered beneficial to pursue the additional unit of production or consumption. Conversely, if the marginal cost outweighs the marginal benefit, it might be preferable to reduce production or consumption.
  4. Optimal Decision-Making: To make efficient choices, individuals should continue producing or consuming units until the marginal benefit equals the marginal cost. At this point, they have maximized their overall satisfaction or utility.
  5. Example: Consider a factory deciding whether to produce one more unit of a product. If the revenue generated from selling that additional unit is higher than the cost of producing it, then the decision would likely be to produce the extra unit. On the other hand, if the cost of production is greater than the potential revenue, it might not be a wise decision to produce that additional unit.

Thinking at the margin helps to explain various economic concepts, such as consumer behavior, supply and demand, pricing decisions, and resource allocation. It is a cornerstone of economic analysis and decision-making because it helps individuals and entities optimize their choices in a world of scarcity and limited resources.

What is the sunk cost fallacy?

The sunk cost fallacy is a cognitive bias in decision-making that occurs when individuals or organizations continue investing in a project, activity, or decision solely because they have already invested significant resources (such as time, money, or effort) into it, regardless of whether the future benefits outweigh the costs. In other words, they let past investments influence their present and future decisions, even when it's economically irrational to do so.

Key points to understand about the sunk cost fallacy include:

  1. Sunk Costs: Sunk costs are expenditures that have already been made and cannot be recovered. They should not affect future decision-making because they are irrelevant to the current situation.
  2. Irrational Decision-Making: The sunk cost fallacy leads to irrational decision-making because individuals base their choices on past investments rather than evaluating the potential future benefits and costs objectively.
  3. Opportunity Costs: When succumbing to the sunk cost fallacy, individuals may fail to consider opportunity costs—the potential benefits they could gain from alternative decisions that don't involve the sunk costs.
  4. Example: Imagine a company that has invested a significant amount of money and time developing a new product that is not performing well in the market. Despite recognizing that the product is unlikely to generate profits in the future, the company continues to invest more money into marketing and development to "recoup" the initial investment. This is a classic example of the sunk cost fallacy.
  5. Overcoming the Sunk Cost Fallacy: To make rational decisions, individuals and organizations should evaluate options based on future expected benefits and costs, without factoring in the sunk costs. If the expected benefits of continuing a project or activity do not justify the future costs, it's often better to cut losses and redirect resources elsewhere.

Recognizing and overcoming the sunk cost fallacy is essential for effective decision-making, especially in business and economics, where resources are limited and optimizing outcomes is crucial. By focusing on future consequences rather than past investments, individuals and organizations can make more rational and economically sound choices.

Graham Watson

Graham Watson has taught Economics for over twenty years. He contributes to tutor2u, reads voraciously and is interested in all aspects of Teaching and Learning.

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