Economics 101: Sunk Costs and Opportunity Costs

We think every day about what it costs to do different things -- 89 cents to buy a pound of organic bananas, seven dollars to see "Lethal Weapon 4," etc. -- but we seldom think about what it costs not to do something, a concept economists call the "opportunity cost."

The opportunity cost of something is essentially the cost of not putting a resource to its best use. Your 89 cents, for example, might better have been spent on avocados and your seven dollars almost certainly would have been better spent on some other entertainment.

Opportunity cost is an important concept to keep in mind when contemplating important financial decisions for your co-op. Sure, your members' money is safest in the bank -- no argument there. But what's the cost? If that money could be better spent buying a new cooler, adding some different inventory, giving your members something to be proud of, the cost of not doing any of those things could be substantial.

Sure, it's a risk to move into a new space, do an expansion. It might end up costing you something. On the other hand, what's the cost of not doing it? This is a fast-paced industry we work in, and none of us lives in a vacuum. Lost sales, lost customers, lost members and lost opportunities to serve your community in the best possible way may well be the opportunity cost of inaction, of failing to move when the time is right.

Does this mean every risk is worth taking, no matter what the cost? Of course not. All we mean is that it is important to consider the cost of not doing things at the same time that you consider the costs of doing them.

A related concept worth highlighting is that of the "sunk cost." Let's say you just blew $10,000 on a market study for a new site, and the study came out lukewarm on all your favorite sites. While it may seem like a wasteful result to spend $10,000 only to stay in the same building you've been in all along, the fact is that moving is not going to get your $10,000 back anymore than not moving would. It's a sunk cost. You can't get it back no matter what you do, so the cost of the study should have no bearing on your move decision (as opposed to the result of the study, to which you obviously should pay some attention). Maybe the best thing you got for your money was an expensive education and some valuable information -- perhaps, in this case, the information that there is no good site in your area.

A poker game provides an illustration of the "sunk cost" concept in action. Say you're at the table with a pair of threes and $20 in the pot, trying to decide whether to blow another $5 to stay in the game. You might win, you might lose, but the fact that you've already blown twenty bucks on a relatively weak hand is not going to make your hand any stronger. That twenty bucks is sunk.

See other articles from this issue: #079 November - December - 1998