# Making Rational Decisions in Economics - The Role of Sunk and Marginal Costs

This material was originally created for Starting Point: Teaching Economics
and is replicated here as part of the SERC Pedagogic Service.

#### Summary

This JiTT exercise uses a real-life example to pose a question to students about the nature of "rationality" as typically used in economics. In this case, the focus is on fixed vs. marginal costs and the use of marginal analysis by economists to make "rational" economic decisions.

## Context:

This JiTT exercise has its origins in a true story that we experienced as a family. We had put down a sizeable deposit on a weekend house rental at a North Carolina beach over the Labor Day holiday. The forecast was for rain all weekend - 100% probability. I jokingly asked my wife as we got ready to leave whether we should instead stay home and work on a myriad of projects that needed completing, since we had just moved into a pre-owned house and needed to unpack, paint, organize, etc.

The JiTT question asks students whether making a decision to go to the beach or stay home based on the pre-payment that was made is "rational" in a traditional economic sense. The question focuses on students' misconception that fixed costs matter - perhaps a lot - in decisions made at the margin: what to do with our upcoming time, energy, or effort.

This question is given the first week of classes in an introductory-level macroeconomics or microeconomics course. The topic to be covered in class is the important role of marginal analysis in traditional economic theory and the lack of importance of fixed costs in this analysis - contrary to what many students would consider "common sense" - for decisions made at the margin.

In standard economic theory fixed costs do matter for a firm's decision on whether to continue to operate or shut down in the long run, but in the short run only marginal costs and marginal benefits matter for rational economic decision-making.

## Learning Goals:

At the end of this JiTT exercise, students will be able to:
1. Distinguish between fixed and marginal costs.
2. Apply marginal analysis to make an economic decision.
3. Apply the concept of "rationality" to a real-life decision.

## Teaching Notes:

Background Information

The basic ideas presented in this JiTT exercise are part of the standard course content in principles-level courses. This exercise would most likely be used very early in the course when the concepts of rationality and marginal analysis are being introduced.

## Warm Up Question:

Last year my wife and I made plans to take our family (3 children) to the beach for the Labor Day weekend, accompanied by another family (with four children). Each family paid a non-refundable beach rental payment of \$350 a couple of months prior to the trip. As Labor Day approached we watched the weekend weather report with growing interest. Bad news! The weather forecaster was predicting rain for the entire weekend! As we packed up the car to go to the beach, I asked my wife if perhaps we should stay home for the weekend, rather than going to the beach. After all, we had recently moved into a new house that needed unpacking (and painting) and the beach forecast was for rain, rain, rain. She responded, "We've already paid \$350 for the beach rental, of course we're going to the beach!" Was my wife's argument "rational," in an economic sense? Why or why not?

Recall that, according to economists, "rational people will undertake an activity as long as the additional benefit of the activity is greater than the additional cost of the activity."

## Selected Student Responses:

### Student Responses used in Class

1. I think I would decide to go to the beach, rather than staying home to unpack and paint. I think the wife's decsion to go to the beach was a good economic decision. To me, the additonal benefit of the activity is greater than the additonal cost of the activity. I feel like if I have already paid for a \$350 trip, if I fail to go I will be wasting money. There will always be more time to paint and unpack. Even if it is raining at the beach, the family might have the additional benefit of spending some quality time together. My opinion of wasting money is alot more important to me than wasting time. I would rather waste time over money any day.
2. No because you will spend most if not all of your vacation inside due to the rain. That time could be spent working on your house. You also save money because you're at home versus being on vacation where you'd spend money on keepsakes, gifts and other needless items. By not going, you also save money on gas and food. The marginal cost of going to the beach outweigh the marginal benefits and thus it is not rational to go the beach
3. Yes her argument is rational at first glance. Because yes you would be losing \$350 a night. But let give this a little more thought. Lets compare what you will lose if you do go and what you would gain by not going."Lets say the family is from greensboro" First you will have the cost of gas about \$100. Then you will have hidden cost such as wipper blades and more use of your brakes. Then you have additional cost such as cost of activites to take place of going to the public beach where there is no cost so lets say an extra \$400. Next lets say you were planing on cooking out for supper now its raining and now you must go out to eat that more money lets say supper for five and tip for two night \$150. Lastly what happens when it rains a the beach people go inside you may order a movie or rent a movie go shoping or what ever it may be so lets say an extra \$200. Ok so instead of staying home you have spent an extra \$850. So you can see that would not be rational, and dont forget by staying home and doing work around the house you would not have to take a day off so there is more money saved so one can see she was not very rational.
4. I believe that your wife's decision was a rational one in an economic standpoint because the non-refundable \$350 deposit could have been used for some other type of activity for the new home. Eventhough the weather did not suit your standards it would be irrational to waste \$350 by not taking the vacation.
5. Well i personally feel that her argument is very rational, because the trip was already paid for and the trip was going to be restfull something that was more worth her time than unpacking at that time. So i think that she was right not to waste that money and take the trip rather than stay home, and unpack, which is far less relaxing than the beach.

### Complete Set of Student Responses

The five responses illustrated above were selected from the total responses for this exercise. To see the full set of student responses, click on the file below:

### Questions

1. Why do you think the author of this exercise selected the specific five responses listed above to show at the start of class and use as the basis for an in-class activity?
2. Given the eighteen student responses, would you have selected a different set of responses to show in class? Why or why not?

## Assessment of Student Responses:

It is useful to use the holistic grading rubric developed by Kathy Marrs (IUPUI) to assess student responses to JiTT questions. This rubric focuses on student effort and clarity of thought more than "correctness" of the answer. See Reviewing and Assessing Student Responses for Kathy Marrs' rubric and more information about assessing JiTT responses.

## The Class that Follows:

For this exercise, when showing the responses in class I might include the following two questions with the four responses listed above (or hand out on a separate piece of paper). These questions then form the basis for an in-class cooperative learning activity.

### Cooperative Learning Activity

In cooperative learning groups, have each person individually develop a response to the questions below, then have students share their responses within their group.
Based on the student responses to this JiTT exercise:
• Which of these responses comes closest to the argument that an economist would make?
• After selecting one of the listed responses, how might you improve the answer, based on your understanding of the material for today?
Next, based on the individual contributions, have each group develop a consensus answer to the questions. Finally, have each group (or a sample) report out to the full class. Assess (or have other groups assess) whether students are able to display the correct economic reasoning in their responses.

Finally, have each student develop a response to the following question and hand in:
• After completing this exercise, what questions do you still have? What concepts are still unclear?

## References and Notes:

Students base their responses on textbook presentations of the role of marginal vs. sunk costs in rational economic decision-making.