A production possibility frontier shows how much an economy can produce given existing resources.
A production possibility can show the different choices that an economy faces.
For example, when an economy produces on the PPF curve, increasing the output of goods will have an opportunity cost of fewer services.
Diagram of Production Possibility Frontier
- Moving from Point A to B will lead to an increase in services (21-27). But, the opportunity cost is that output of goods falls from 22 to 18.
- At point D, the economy is inefficient. At point D, we can increase both goods and services without any opportunity cost.
- Pareto efficiency is any point on the PPF curve. On the PPF curve, it is impossible to increase one choice, without causing less production of the other.
Economic Growth
If there is an increase in land, labour or capital or an increase in the productivity of these factors, then the PPF curve can shift outwards enabling a better trade-off.
Graph showing increase in PPF.
Note: there is a link between macroeconomics and the long-run aggregate supply curve. If the PPF curve shifts to the right, then it is similar effect to the LRAS shifting to the right
Production possibility frontier and investment
One choice an economy faces is between capital goods (investment) and consumer goods.
- If more resources are devoted to capital goods (e.g. building new factories) then in the short-term, consumption will go down.
- However, if the investment is successful, then in the long-run, productive capacity will increase and the PPF curve will shift to the right
Increase in capital goods has an opportunity cost of fewer consumer goods, but in long-term can enable economic growth.
Similarly, a decline in investment can enable more consumer goods in the short-term but can lead to lower rates of economic growth.
PPF and recession
A recession can be shown by output falling below the production possibility frontier (from A to B).
- A = full employment
- B = unemployed resources
PPF and choices for government
Any government faces a trade-off in how to use scarce resources and tax revenue. If the government increases spending on the military, then the opportunity cost will be less spending on another public service, such as health care.
Different PPF Curves
Opportunity Cost Definition
Definition – Opportunity cost is the next best alternative foregone.
- If we spend that £20 on a textbook, the opportunity cost is the restaurant meal we cannot afford to pay.
- If you decide to spend two hours studying on a Friday night. The opportunity cost is that you cannot have those two hours for leisure.
Importance of opportunity cost
The fundamental problem of economics is the issue of scarcity. Therefore we are concerned with the optimal use and distribution of these scarce resources. Wherever there is scarcity we are forced to make choices. If we have £20, we can spend it on an economic textbook, or we can enjoy a meal in a restaurant. Therefore, many choices involve an opportunity cost – having to make choices between the two.
Production possibility frontier and opportunity cost
A production possibility frontier shows the maximum combination of factors that can be produced.
- Moving from Point A to B will lead to an increase in services (21-27). But, the opportunity cost is that output of goods falls from 22 to 18.
- Therefore, the opportunity cost of increasing consumption of services is the 4 goods foregone.
At point D, the economy is inefficient. We can increase both goods and services without any opportunity cost.
C is currently impossible.
Examples of opportunity cost
The cost of war. If the government spends $870bn on a war, it is $870bn they cannot spend on education, health care or cutting taxes / reducing the budget deficit.
Spending on new roads. If the government build a new road, then that money can’t be used for alternative spending plans, such as education and healthcare.
Tax cuts. If the government offers an income tax cut, the opportunity cost is that government revenue cannot be used to finance some aspect of government spending.
Time. If you have 12 hours at your disposal during the day, you could spend these hours in work or leisure. The opportunity cost of spending all day watching TV is that you are not able to do any study during the day.
Enter the workforce at 16. If you enter the workforce at 16 without qualifications you start earning money straight away. But the opportunity cost is that you lose out on the potential of getting better qualifications and possibly a higher salary in the long-run.
Example of Actual Opportunity Cost
Suppose you buy a new car for £10,000. After three years it has depreciated in value to £3,000. What is the opportunity cost of deciding to keep the car?
- The opportunity cost of keeping the car is the £3,000 you could have got for selling the car. The price you bought it for is not relevant here.
Importance of opportunity cost
- Do you support the repeal of the estate tax if that means you pay tax on inherited money?
- Do you support the repeal of the estate tax if you have to pay a higher rate of VAT?
See this interesting survey which shows people have very different responses when they understand the opportunity cost involved in a tax cut.
Opportunity cost and comparative advantage
The theory of comparative advantage states that countries should specialise in producing goods where they have a lower opportunity cost.
Opportunity cost and a free good
If there is no opportunity cost in consuming a good, we can term it a free good. For example, if you breathe air, it doesn’t reduce the amount available to other people – there is no opportunity cost.
Present bias
Present bias occurs when individuals place a greater value on goods/income achieved in the present moment – rather than receiving the same goods/income in the future.
It suggests given a choice between a payoff today and a pay off in the future; we will choose to have the pay off now.
It suggests that people can be time-inconsistent – making decisions that their future self may regret.
“Casual observation, introspection, and psychological research all suggest that the assumption of time consistency is importantly wrong. It ignores the human tendency to grab immediate rewards and to avoid immediate costs in a way that our “long-run selves’ do not appreciate.”
– Ted O’Donoghue and Matthew Rabin, “Doing it now or later” (1999)
Hyperbolic discounting and time-inconsistent
This occurs when we discount the value of rewards in the future at a factor that increases with the length of the delay.
“When considering trade offs between two future moments, present-biased preferences give stronger relative weight to the earlier moment as it gets closer.”
Ted O’Donoghue and Matthew Rabin “Doing it now or later” (1999)
Example of time-inconsistent behaviour
If you were asked in twelve months time whether you would work an extra seven-hour day on April 1st or an extra eight hours on April 30th, most would choose the seven hours on April 1st.
However, if next year on March 30th, we were asked the same question, we would be more likely to choose the eight hours on April 30th. The thought of working seven hours the next day is enough to put it off for four weeks. This is time-inconsistent as we choose differently depending on how close in the future the choice is.
Reasons for time-inconsistency
One thing worth bearing in mind is that if you were offered payment of £1,000 or £1,100 in a week’s time, you may feel there is a higher probability of receiving the £1,000 now, rather than £1,100 in a week’s time. For a firm getting payment for bills, they would rather have money now, rather than the riskier option of getting payment + interest in the future.
Implications of present bias
- Insufficient saving for pensions. We discount the value of future pension payments and save insufficiently
- Consumption of demerit goods. We ignore future health costs for the short-run utility of enjoying the drug.
- Delaying decisions. Given a choice between doing a project now, when we have time, we may put off until last moment, when we are tired and can’t do as well.
Responses to present bias
- Nudges. Governments/pension companies may give us incentives to nudge us into taking out pension commitments.
- Highlight costs of goods. Government campaigns to highlight the costs of consuming demerit goods or taxes to make them less palatable.
Sunk Cost Fallacy
The sunk cost fallacy is when we continue an action because of our past decisions (time, money, resources) rather than a rational choice of what will maximise our utility at this present time. For example, because we order a big meal and have paid for it, we feel a pressure to eat all the food.
“The sunk cost effect is manifested in a greater tendency to continue an endeavor once an investment in money, effort, or time has been made.”
Hal Arkes and Catherine Blumer. (1985), The psychology of sunk costs. Organizational Behavior and Human Decision Processes, 35, 124-140.
Definition of sunk costs
A sunk cost is an irretrievable cost. It is a cost that we cannot get back. For example, if we spend $1 million on advertising ‘mini-discs’ you cannot reclaim this money from advertising agencies. If you buy a factory, you will be able to sell the capital and reclaim some money.
Making decisions at the margin
An important issue in economics is making decisions at the margin. What are the marginal benefits and marginal costs of deciding to continue with investment? When we make decisions at the margin, we discount any sunk costs. Because these historic costs do not affect future marginal benefits and marginal costs.
“It’s no use crying over spilt milk”
It is like the analogy of ‘no use crying over spilt milk’ Once the milk is spilt, we can’t change that action. If someone wasted money in the past, that action cannot be changed, we need to focus on the best decision at the present moment.
Sunk costs in business
In business, a sunk cost fallacy can cost a business greater financial losses. For example, suppose a firm invested $1bn in research for developing a more efficient CD player, it may feel that because it has invested $1bn, it should continue with more research until it can bring it to the market and get something back for this $1bn. However, if CD’s are no longer selling, it would be more rational to write off these sunk costs, rather than wasting more money on developing a product which will never make a profit. However, if managers were attached to past investment they would keep going – even though it leads to bigger loss in the future.
Examples of Sunk Cost Fallacies
- Using a product to get your money’s worth. Suppose you take out a 12-month gym membership, costing $40 a month. You have committed to spending 12*$40 = $480. Once you have signed your contract, you have effectively committed to $480. It is now a sunk cost – you can’t get it back. Whether you go to the gym or not, makes no difference to the sunk cost.
Now, suppose you injure your arm, the utility maximising decision would be to not go to the gym. However, because of the investment of $480, we may feel we need to ‘get our money’s worth’ and therefore, we go to the gym even though we would actually be better off resting at home.
Of course, some people may take out a gym membership because they know if they commit to spending $40 a month, it will create an incentive for them to go and work out!
2. Investment in ‘white elephants’ or ‘Concorde Fallacy’
Concorde was a supersonic passenger jet, which was a joint project between the French and British governments. After a period of significant investment, it became apparent that the project was likely to be a bad financial investment. Costs were high, and revenue was limited. However, because a lot had been invested in the project already, it was decided to continue with the project causing further financial losses – rather than writing off the sunk costs and accepting initial financial losses. (There were also political reasons for continuing with investment, such as Britain’s entry to the Single Market)
Pursuing a career because of an investment in education
Suppose, you spend seven years gaining a degree and qualifications to be a lawyer. The investment in education is now a sunk cost (in terms of time and money). However, once qualified, you find you don’t like the job and want to do something different like open up a cafe. If you wish to honour the sunk costs of education, you will continue to work as a lawyer, despite not enjoying it. However, if you ignore these sunk costs, you are free to make a choice about which career you prefer to do.
Honouring purchase because of a cost
Suppose you bought a ticket for a concert at $100. However, on the night of the concert, you remembered you have an exam the next morning. The $100 is a sunk cost – you can’t get it back. However, you feel, that since it cost so much you should go – otherwise you’ve wasted $100.
However, if you had been given the ticket for free, you would find it much easier to stay home and revise – because you don’t have any attachment to the ticket.
Example – 7 cakes
Suppose you buy seven cakes for £5.00 costing £35.00 – how much should you eat?
- The 5th cake gives zero marginal utility – total utility stays the same.
- But the 6th cake gives negative utility – 30 utils.
- If you eat the 6th and 7th cake because you have bought it, you are making yourself worse off.
- It is better to throw away the last two cakes. The fact you spent £10 on them is no longer relevant.
Related concepts
Mental accounting
For example, if we win £40 on a lottery ticket, we may feel that this bonus win enables us to spend on going out for a meal. However, if we got a tax rebate of £40, we would be more likely just to save it.
Mental accounting is related to concepts of
Transactional utility – the perceived joy we get from the quality of the buying transaction – ‘deal’. If we see a piece of clothing 50% off, we are happy to get the deal and may buy more clothes because we now have more in our ‘clothing budget’ than expected.
Sunk cost fallacy – If we spend money on an item, our ‘mental accounting’ can make us feel we should try and get value from our past purchase. For example, if we buy an expensive ticket, we may feel obliged to go to the concert, even in a snowstorm or if we are very busy. If the ticket was received free, we have no feeling of a sunk-cost so feel happier to miss the concert if it is not in our interests.
Pain of paying – If we have $10,000 in the bank account, but get an unexpected $50 parking fine, we may feel we ‘can’t afford to spend $50 going out’ because we have just had this unexpected loss of $50 on parking. Not going out is a way to get this $50 back. In this sense, we focus more on the visible $50 we pay, rather than the less visible $9,950 in our bank account.
Loss aversion. Investors can be subject to loss aversion. If we spend $1,000 on a stock, there is an aversion to selling at a loss, but an incentive to sell at a small profit. If investors frequently check their stocks, it can make them risk-averse and sell as soon as stocks move into profit. It can make investors reluctant to sell at a small loss because that stock would be deemed a ‘failure.’ when we close that particular account. But, this can lead to irrational investment behaviour. It is better to sell at a small loss than risk an even bigger loss.
Richard Thaler and Mental accounting
Richard Thaler’s paper on Mental Accounting Matters (1999) is considered the most important work on this aspect of behavioural economics
Thaler states the three aspects of mental accounting which receive the most attention:
- How outcomes are perceived and experienced and how decisions are made and subsequently evaluated.
- The assignment of activities to specific accounts
- The frequency which accounts are evaluated
Examples of mental accounting in practice
Thaler observed a friend who came across a sale of bedspreads. They came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale, they were all priced at only $150. His friend bought the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed.
Here there is an incentive to buy a bigger quilt than necessary, because of the transactional utility from getting a $150 discount. The double sized quilt may have been more appropriate, but that purchase only gains $100 discount. The desire for transactional utility can encourage us to make irrational purchases.
Would you replace a lost ticket?
Kahneman and Tversky (1984) investigated whether people would purchase a theatre ticket after:
- Losing an original ticket
- Losing the equivalent amount of money.
They found that people were more willing to purchase a ticket after losing the equivalent sum of money. They were less willing to buy a ticket after having lost their original ticket.
One explanation is that after we have spent $50 on a concert ticket, our mental budget for concert tickets is already constrained.
Mental accounting and means of payment
It has been observed that payment by credit card reduces the salience and vividness of payment and can make it easier to purchase goods on credit card than paying with cash. Our mental account for spending cash is smaller than our mental account for putting onto a credit card.
Soman (1997) finds that students leaving the campus bookstore were much more accurate in remembering the amount of their purchases if they paid by cash rather than by credit card.
Income accounting
Shefrin and Statman (1984) state investors like dividends because it provides a simple self-control rule. Investors feel confident to spend dividends and leave capital alone.
Camerer et al. (1997) found that New York taxi drivers exhibited the behaviour of targeting a set level of earnings per day. In other words, on busy days when demand for taxis are higher, they can gain their target income quicker and so work shorter days. Inversely on quieter days, it takes longer to earn their target income and so spend longer. This leads to a situation of more taxis on quiet days and fewer taxis on busy days.
Personal experience of mental accounting
Recently, I had an unexpected charge hiring a car. The firm charged £800 for small dint. I have applied to my third party insurer to claim the £800 back. If I get the £800 back from the insurance company, I feel like I will be happy to support a charitable project (a friend in need). However, if they don’t pay up, I won’t be able to support the charitable project. In other words, getting £800 back would be a bonus; if gained, I’m more inclined to help a friend. But, if I have to absorb this loss of £800 I’m not willing to dip into my main bulk of savings.
In theory, I should treat all money as fungible, but it is very tempting to separate money into main savings and unexpected bonus/loss.
Prospect Theory
Prospect theory – “An essential feature of Prospect Theory is that carriers of value are changes in wealth or welfare – rather than final outcomes.” and “Losses loom larger than gains.” This can explain why we may not want to sell a house at a loss even if we might be better off.
Prospect theory is an economic theory which tries to describe the way people will behave when given choices which involve probability.
Prospect theory assumes that individuals make decisions based on expectations of loss or gain from their current relative position.
“An essential feature of Prospect Theory is that carriers of value are changes in wealth or welfare – rather than final outcomes.”
An important element of prospect theory is the idea that individuals are particularly averse to losing what they already have and less concerned to gain.
“Losses loom larger than gains”
Given a choice of equal probability, individuals would choose to preserve their existing wealth, rather than risk the chance to increase wealth.
Prospect theory can explain why people exhibit both risk-seeking and risk-averse behaviour.
Creation of Prospect Theory
The first instance of this theory was proposed by Daniel Kahneman and Amos Tversky in “Prospect Theory: An Analysis of Decision under Risk” (1979)
Features of Prospect Theory
Prospect theory places emphasis on how individuals frame situations and outcomes in their mind. Individuals may use rules of thumbs and the status quo bias.
- Certainty effect: People give greater weighting to certainty than outcomes that are merely probable.
- Reflective effect. In terms of positive gains, people give greater weighting to a small certain gain over a probable larger gain. But, in terms of negative gains, people exhibit risk-seeking behaviour – people preferring a loss that is probable over a small loss that is certain. (this seems to contradict the desire for insurance, but it is for moderate losses, rather than catastrophic losses.)
Model
In the editing phase, people decide which outcomes they consider equivalent, set reference points, simplification and combining probabilities.
In the evaluation phase, people compute utility based on the probability of certain outcomes, then choose alternatives with higher utility.
Prospect Theory differs from Expected Utility theory
Expected Utility theory assumes individuals will choose the outcome which gives maximum utility given the probability of outcomes.
Prospect theory allows for the fact that individuals may choose a decision which doesn’t necessarily maximise utility because they place other considerations above utility.
Is the sunk cost fallacy always a fallacy?
Ryan Doody argues it is not always irrational to make decisions because of sunk costs. Doody argues that if we invest in a project, we may wish to continue with investment to hide our flaws and exhibit a strong reputation. If a firm invests in a high profile project, it may be better to make continued losses rather than the reputational harm of admitting it made a failure.
“Acting so as to hide that you’ve suffered diachronic mis-fortune involves striving to make yourself easily understood to others (as well as your future self) while disguising any shortcomings that might damage your reputation as a desirable teammate.”
Economic studies
- Psychology of Sunk cost – Hal Arkes and Catherine Blumer Organizational Behavior and Human Decision Processes, 1985, vol. 35, issue 1, pages 124-140
