Marginal Thinking, Incentives and Sunk Costs
5 min read
Lesson objectives
- Use marginal benefit and marginal cost to make a simple incremental decision.
- Distinguish a sunk cost from a relevant future cost.
- Explain how incentives can change behaviour while recognizing possible unintended effects.
The next decision matters more than money already gone
Marginal thinking asks about a small additional change: what extra benefit comes from one more unit, and what extra cost does it create? In a simplified model, additional units are worthwhile while marginal benefit exceeds marginal cost under the chosen measure. A sunk cost is a cost already incurred that the current decision cannot recover; an activity should not continue merely because that cost has already been paid.
Notice that we did not compare average benefit or total spending; we evaluated the next unit. Marginal cost or marginal benefit can change from one unit to the next, so a good decision for the first unit does not automatically remain good for the fifth.
Relevant cost versus sunk cost
Incentives change expected behaviour
An incentive is a factor that changes the expected benefits or costs of a behaviour. It may involve money, time, information, convenience or reputation. Its effect depends on context and alternatives; calling something an incentive does not tell us the size of the response. Unintended effects can also arise if a system rewards one number while ignoring quality.
| Question | What to examine | What to avoid |
|---|---|---|
| Marginal decision | Benefit and cost of the next unit | Relying only on averages |
| Sunk cost | What can still change in the future | Continuing because the past was expensive |
| Incentive | How expected benefits/costs change | Assuming one response in every context |
Lesson summary
Marginal analysis focuses on the next additional unit, comparing its benefit with its cost rather than relying on averages alone. A sunk cost is a past, unrecoverable cost that does not change with the current decision. Incentives change expected benefits or costs, but responses depend on context.