Thursday, December 8, 2011

Another shopping tip: Consider opportunity costs

As we approach the holidays many of us are doing a lot of shopping.  We buy gifts for family and friends, and we also pick up a few things for ourselves, taking advantage of holiday sales. 

It ought to seem obvious that every dollar we spend on one purchase is a dollar that we can’t spend on another purchase.  Economists would say that each purchase has an opportunity cost.  Once we have made that purchase, that money cannot be spent on something else in the future.  To what extent do these opportunity costs affect the purchases we make?

A paper by Shane Frederick, Nathan Novemsky, Jing Wang, Ravi Dhar, and Stephen Nowlis in the December 2009 issue of the Journal of Consumer Research suggests that people often ignore opportunity costs for a purchase. 

They start their paper with a compelling story.  One of the authors of their paper was trying to decide between two stereo systems, one of which cost $1000 and had somewhat better speakers than a second system that cost $700.  After agonizing over the choice, the salesman asked whether he would rather have the better system or the cheaper system and $300 worth of CDs.  Immediately, he selected the cheaper stereo.  That is, even after putting in a lot of effort to think about this choice, the shopper had not considered the prospect that money not spent on the stereo would be available for other purchases that might enhance the quality of the stereo.

In a series of studies in this paper, the authors set up a number of situations in which people had to make choices.  In some cases, they chose between purchasing an item (say a DVD) and not purchasing it.  In other cases, they chose between a more expensive option and a less expensive option.  In each case, people were far more likely to purchase the cheaper option (or not purchase at all) if they were reminded of the opportunity cost of making the purchase.  These results suggest that people generally ignore opportunity costs when making choices.

People tend to ignore these opportunity costs in a variety of settings beyond just shopping at the holidays.  For example, the University of Texas is working hard to help students graduate from college in 4 years.  An increasing number of students are staying in college for a fifth year.  Often, the students reason that tuition for that fifth year is not so expensive.  However, the students who make this choice are typically not factoring in the opportunity cost of the extra year in school.  There is salary that they are not making for that year, as well as other ways that they may have chosen to spend their time.  Some students may elect to stay in school for an extra year even after considering these opportunity costs, but many students have never considered them at all when making this decision.

So as you do your shopping in this holiday season—and as you make important decisions in the years to come—spend some time thinking about how opportunities in the future may be affected by the choices you are making now.