The Economics of Spilt Milk

Movie Tickets, Career choices, and Sunk Costs.

There is no use crying over spilt milk


It's one of the most obvious things in the world (is it?). There is no point crying over spilt milk. It's spilt. Nothing you can do about it. It's a very graphic example. It hits you especially hard when you actually do spill something (or break something) and just stare mournfully at it.

It's all very well to say that about spilt milk but is there some deeper principle at work here that can apply to other (more important) aspects of life?


Let's go to the movies


To me, the underlying principle is best explained using a classic example.

Thought Experiment:

Assume you want to go to a movie (X). You pay Rs 120 to buy a ticket and start to get inside the movie hall.

However, when you reach the hall, you discover that you've lost the ticket.

What will you now do?

• Will you go back home and do something else?
• Or, will you pay another Rs 120 and go for the movie?
  You know that the movie isn't worth Rs 240. Will you still go?

Think about it for a moment.

If you're like me, it would seem obvious that since the movie is not worth Rs 240, it would be a waste to pay another 120 rupees (paying Rs 240 in total) for the evening's entertainment. Heck, you and I might even be so pissed off at having lost Rs 120 that we may just head back home in anger.


The Economics of lost movie tickets


Hmm... Wait a minute, though. Let's look at this from an Economics standpoint.

1. What is the benefit you get from the movie?
   
   First off, since you paid Rs 120 for the ticket in the first place, we can conclude that you consider the movie worth at least Rs 120. That means, you are getting more than Rs 120 worth of entertainment from the movie. Also, since you aren't willing to pay Rs 240, we can say that you value the movie less than Rs 240.
   
   So, let's assume you get a benefit of Rs 160 from the movie. In other words, if the ticket cost Rs 160 or less, you'd go, since you would get a profit. And if it cost Rs 161 or more, you wouldn't, since you would make a loss.
2. What is the best thing you can do over the next 2 hours?
   
   Here's another major point. Let's assume the movie runs for 2 hours. You decided to go for this movie, hoping to watch it during those 2 hours. Which means, if you had made a rational decision, you'd judged that you would rather be doing this during those 2 hours than anything else in the world. Basically, this was the best thing you could have done. In other words, the benefit you got from this was more than the benefit you would have got from any other activity.
   
   For example, if you had watched the movie, you would have got a net profit = Rs 160 of entertainment - Rs 120 for the ticket = Rs 40.
   
   If you had chosen to sit at home and watch TV, we can safely say that you believed your profit there would have been lesser, say Rs 20 or so in entertainment.
   
   So, the best thing you could do over those 2 hours was watch the movie.

Movie vs TV


Now, let's revisit the situation. You've lost the ticket you bought earlier. That means you've lost Rs 120. Should you buy a ticket again?

What alternatives do you have?

You could go back home and watch TV. Or something else. And, of course, you will get some benefit from doing one of those activities.

eg. You may gain Rs 20 in entertainment by watching TV. Watching TV for the next 2 hours would cost nothing. You aren't paying any extra fees to watch TV for the next 2 hours.

But we pay a monthly cable bill? Shouldn't that be counted?

Nope. Rational people think at the margin. There may be an average cost to watching a show (= Monthly bill amount / No of shows watched), but the cost of watching one extra show is Rs 0. Once you've paid the bill, you can watch just about as many shows as you can stomach. No extra fees.

So, that sounds great! Why pay another Rs 120 for a movie when you can watch TV for FREE!!

But, from Point 2, we know that you had assessed the benefit of watching the movie (Rs 40) more than ANYTHING else you could do. That's why you had decided to spend the next 2 hours watching the movie and not anything else.

Even now, after having lost the ticket, nothing has changed. The best thing you can do in those 2 hours is still to watch the movie.

Remember, the lost ticket, worth Rs 120, is like spilt milk. There is no point crying about it. In fact, since there is ABSOLUTELY nothing you can do about it, it should have no effect at all in your decision making. It's already gone. Look to the future. And what does the future, more specifically the time period of the next 2 hours, hold?

1. You watch the movie by paying Rs 120 again, you get Rs 160 back in  entertainment. Net profit = Rs 40.
2. You watch TV. Net profit = Rs 20.
3. You do anything else. Net profit < Rs 40.

Which means that what you should do is watch the movie. There is nothing better you can do in the next 2 hours than watching the movie.

Don't blame yourself if the above analysis was a bit counter-intuitive (or vague).

It took me a long time to get it even theoretically and it is only just starting to make its impact on my life.


Sunk Costs are Irrelevant

Sunk Costs: costs that have already been committed and cannot be recovered.

eg. The cost of the lost movie ticket.

Sunk Costs are the spilt milk of economics. There is no point crying over spilt milk. And there is no point worrying about Sunk Costs. They're both gone.

So, what? How can you be better off paying Rs 240 for a movie and getting Rs 160 back than paying Rs 0 for TV and getting Rs 20?

You can't.

But, remember there are hidden costs that weren't accounted for in the above equation.

Look at the net balance for the day. You've already lost Rs 120. It's gone.

Now you have 2 hours left.

  Case 1 : If you watched the movie,

  BALANCE SHEET

  Net Cost:
  First Ticket (Money already lost) = Rs 120
  Second Ticket = Rs 120
  Total = Rs 240

  Net Revenue:
  Movie Entertainment = Rs 160
  Total = Rs 160

  Net profit = Net Revenue - Net Cost = Rs -80

I told you so!!! You will lose money if you buy another ticket. You are a dumba$$.

  I know. Wait a minute, though.

  Case 2 : If you watched TV,

  BALANCE SHEET
  Net Cost:
  First Ticket (Money already lost) = Rs 120
  Cost of TV Show = Rs 0
  Total = Rs 120

  Net Revenue:
  TV Show entertainment = Rs 20

  Net profit = Net Revenue - Net Cost = Rs -100

Whoa! That was a surprise. You will actually lose Rs 20 more if you went back home and watched TV. In fact, you will lose more money if you do anything else but watch the movie.

That was another way of coming to the same conclusion - Sunk Costs are irrelevant. They simply get added to the cost of every option you consider next. Which means they can be safely ignored when trying to compare between many options.


Relevance of the Irrelevant Sunk Costs to our lives


As you can probably guess, this principle has wide-reaching implications, ranging from the trivial to the life-changing.

Here are some examples:


1. Awful movies and Sunk Costs

Have you ever paid for a movie ticket and found out that it was worse than the worst movie you had ever seen?

I was in that situation a week or two ago when I found myself going to *gasp* Twilight: Breaking Dawn - Part 1. 20 minutes into the movie, precisely when the initial food I'd bought ran out, I realized that I was watching one of the most boring movies I'd ever seen. The food had prevented me from noticing how bad and immature the movie was. 10 minutes later, after fidgeting in my seat and trying to watch the movie from several angles, I wanted to run out.

So, what happened then? I ran out, right? Nope. I sat there. For the next how many ever minutes till the movie finally ended. Why did I sit there? The story or plot was razor-thin. There was nothing exciting about the movie at all. Anything would have been better than watching the rest of it. I could have walked around the mall or just chatted with my friends. Anything. And yet, I stayed. Why? Because I'd already paid for the ticket and I didn't want my money to go in vain.

If you've ever been in a situation where you've already paid for something which is turning out to be WAY below your expectations, you will be pleased to learn that you were justified in thinking that you should have walked out of that situation immediately.

The price you paid for a movie that turned out to be awful, for a rented DVD that you don't have time to watch because there is so much other exciting stuff going on (like exams and shit, you know :P), or for a library book you rented a loooooooong time ago and never read is irrelevant now.

All that matters is whether something else will give you more happiness than this movie/book or whether this is more pleasurable. That's all that needs to be looked at in your decision-making.

There is no point in forcing yourself to watch the movie or read the book just because you bought it.


2. Food

Same goes for some dish that you try experimenting with at a Chinese restaurant, for example.

You find that it sucks to the core and tastes horrible, but you've already ordered it. At Rs 100 for the dish, you had better eat every damn strand of that goddamn mash of noodles and whatnot. Right? NO! It's not worth it.

Or a dish you ordered thinking you'd be able to eat it, but now your stomach is full enough to burst. Should you eat it? You've already lost what you paid for the dish. Now, you'll end up having stomach-ache as well.

Starting something does not justify ending it.


3. Bad Investments

A more serious example - Say, you've invested in the shares of a particular company, a certain CupMax Ltd., in the past. You've put in Rs 10 Lakhs over the last year. You've received no profit for any of that. That money is pretty much gone. They're not doing very well. However, there is now a new CEO. He has a good track record and guarantees that if you invest Rs 10 Lakhs more now (for a total of Rs 20 Lakhs of investment), you'll get Rs 30 Lakhs back. A 50 % profit only. That sounds like a Cup company, indeed.

Another company, StudMax UnLtd., says that if you invest just Rs 10 Lakhs, you'll get Rs 20 Lakhs back. 100 % profit. Wow!!! Sure is a Stud company! Here's my cheque!

However, from what we know about Sunk Costs, we should not include the Rs 10 Lakhs lost the previous year in our calculations. It is exactly the same logic as for the movie ticket example.

The comparison is now simply based on next year's performance.

     Rs 30 Lakhs for Rs 10 Lakhs by CupMax.
     Rs 20 Lakhs for Rs 10 Lakhs by StudMax.

The answer is a no-brainer. CupMax Ltd. FTW!


4. Bad Investments - Twist

Conversely, if you've been investing in CupMax Ltd. for a year and have lost about Rs 10 Lakh and are now given this choice -

     Rs 20 Lakhs for a further Rs 10 Lakhs by CupMax.
     Rs 30 Lakhs for Rs 10 Lakhs by StudMax.

you shouldn't hesitate to jump to StudMax and get more. It doesn't matter that you've invested in CupMax so far or that the 10 Lakhs have already gone down the drain. Sunk Costs are irrelevant.


5. The Great Gym Secret

How do Gyms make money?

Presumably by having good equipment and facilities and advertising well enough to have a bunch of guys and girls come and beef themselves up or get rid of their spare tyre, as the case may be.

How do Exercise Equipment manufacturers make money?

Presumably by building good equipment that burns fat like nothing and advertising non-stop on TV.

That may be the case in general, but there is a particular pattern to the earnings of both the gym owners and equipment companies.

Ever made a resolution that you will lose 5 kg in the coming year? Or that you will start living a healthier life by exercising regularly and stuff? Ever felt that rush - "I'm going to do it!" - and visualized yourself as the lean, mean machine of your dreams?

And then seen it fall flat? With nothing happening at all past the first couple of weeks (or maybe months) before life inevitably intervenes and screws up your plans?

This prevents most people from even making a resolution. They've failed too many times in the past to have any more over-optimistic faith in their own will power.

Some people are smarter. They go out and get a gym membership. For the entire year. Costing them upwards of Rs 6000.

Or they buy a costly piece of home exercise equipment - a treadmill or bike.

The logic behind their decision is that the fact that they've spent a fortune on the membership/equipment will keep weighing on their mind and motivate them to use their membership/equipment regularly. After all, we *hate* to lose stuff, especially money.

Naturally enough, gyms have a bonanza during the last few days of the year and early in the new year. People believe in the above logic strongly enough to buy some really costly membership plans.

And where does all this clever scheming get them? In the same position as they were earlier. Why? Why does it backfire?

Because, when push comes to shove and you are faced with a usually uncomfortable action (like waking up at 5 am - 5 am, forgodssake! - and busting your a$$ on the treadmill for half an hour), your mind starts to apply economic principles like nobody's business.

3 months into the new year, when any trace of the "rush" you had at the of start the year has vanished, the Rs 10000 you paid for a Gold membership is a distant memory. More importantly, the cost-benefit analysis is unequivocally tilted towards lethargy.

Assuming you hoped to hit the gym 100 times this year, the average cost of a gym trip would be Rs 10000 / 100 = Rs 100. Which means, each session you bunked would cost you on average another Rs 100. And so, to save that Rs 100 (by using the gym for a session), you hoped you would keep hitting the gym. That was the logic.

But, remember that the payment was made as a lump sum at the start of the year. Which means that the cost of one extra gym trip is Rs 0. Your mind correctly sees the Rs 10000 as a Sunk Cost and eloquently persuades you that nothing is going to be achieved by jumping out of bed at 5 am in the morning and hauling a$$ in the gym.

IMHO, a better option, hypothetically, would be to arrange for Rs 100 to be burnt in front of your eyes every time you missed a session. That way, the whole dynamic changes. Your incentives change dramatically.

If you go to the gym, the Rs 100 will be paid to the gym, BUT, you will gain benefits worth, say, Rs 120. Which means you would be better off by Rs 20.

If you miss a session, then you stand to lose Rs 100. Every time.

What would you rather do - gain Rs 20 or lose Rs 100? :)


6. Switching career paths

Say you're studying Engineering in an undergraduate college. You aren't all that excited about your field but it's kinda ok, you suppose. You can gain admission into a good college abroad (which is a synonym for the US) in your field.

What if you now suddenly rediscover a long-lost passion for Business and Management? You talk to some adult MBAs and they tell you that you seem to have the right aptitude and all that sort of shit. You feel really excited about it. What if you get this crazy idea that you should throw your four years of hard-core scientific engineering background and go "sell soap"? Should you? Are you nuts, like your parents assure you when you tell them about this sudden passion?

Four years of world-class, hard-core mugging. Should you let it all go in vain? You know that you can get an equivalent salary in the Management field (or even better) as compared to a Core job. But should you do it?

Instead of giving a solid answer to the above, I'll just raise a small point. All that time you spent in college - four years of it, toiling in classrooms, labs, exam halls - is a sunk cost. All that money spent - everything - is a sunk cost. You cannot get it back.

If the long-term benefits of an MBA career for you outweigh the benefits of a core career, there should be no hesitation about jumping. IMHO, all that pejorative talk about being a traitor and going to sell soap, etc. is just bullshit.

It is most efficient for you to do what you are best at. End of story. Nothing else matters. In the long run, you'll end up being better off than you would have been pushing yourself in a Core job. Sunk costs are irrelevant.


7. Relationships

The same logic holds for relationships as well, though it is much more controversial to say so.

Just because you've been with a person for a long time (as a friend or romantic partner or whatever) doesn't mean you should continue to do so when he or she becomes a world-class a-hole and resists all your efforts to reform him or her.

There shouldn't be any shame in walking away from abusive relationships - whether it be physical, sexual, plain verbal bullying and harassment, or just plain unbearable bitchy behaviour.

Like they say,

Today is the first day of the rest of your life.

Why would you want to spoil the rest of your life by living in harmful relationships? Life is too short for that kind of masochistic bullshit.


Conclusion


We've seen that Sunk Costs are irrelevant to our decision-making and that there is after all no point at all in crying over spilt milk.

I'm sure that there's tons of ways to apply this principle in our lives and become better off. Hopefully, as time passes, I'll come across more and more such ways.