When discussing an earlier article about sunk costs with an acquaintance, he expressed agreement about how important, and yet, little understood this topic was. He told the story of an experience he had at work where he wished he had been equipped to explain to his boss and co-workers the concept of sunk costs and how it applies to their business.
A sudden and vicious storm had come over the business’s property and knocked over a quite a few trees. The owner, and this man’s boss, was very concerned over the wasted value of the trees and decided that his employees should go around the whole property and cut up the fallen trees. He was sure that they could find uses for the wood, either burning it for heat in the winter or selling it as firewood. This employee was baffled by this decision, as they weren’t in the firewood selling business.
There were three points he made to his boss about this decision:
1) The time it would take for the employees to chop up all the wood, move it to a storage location, and advertise the wood for sale, would be very expensive to the company—both in terms of the employees’ wages and lost productivity during that time.
2) If they were to burn the wood to try to save money on heating costs in the winter, the wood-burning would be much less efficient than their heating system and would again require employee time to tend.
3) The sum cost of employees’ wages and lost productivity, even with the added income of selling firewood, was much more expensive than the cost of hiring a tree removal company to come haul the wood away.
They eventually called a tree removal company. The owner in this case is not alone. As we have discussed, all our lives we are taught to be good stewards by not being wasteful. The idea of not doing something useful with the fallen trees is in many ways counter-intuitive. But notice, in this case, it wasn’t just that the owner didn’t want to be wasteful, he thought that this act of nature could save his company money in heating costs and could even make them money if they sold firewood. This is more than a misunderstanding about sunk costs, it also demonstrates another common misunderstanding—the broken window fallacy.
Our friend Dr. Art Carden has explained this fallacy for Learn Liberty quite well. While the whole video is worth watching, the gist is that the broken window fallacy says that if a kid throws a rock through a shop window, the shopkeeper then has to spend money to fix the window, which creates jobs for the glazier who then spends it somewhere else and money begins coursing through the economy. Frederic Bastiat addressed this fallacy in his essay “That Which is Seen and What is Not Seen.”
[pq]The broken window doesn’t cause economic activity, it merely redirects it.[/pq]
Bastiat’s argument is that if the shopkeeper doesn’t have to spend his hard-earned money on replacing the window, he’ll spend it on something else—something that he wants for himself, for his family, or for his shop—or he will place the money in a savings account, allowing it to be loaned to other businesses. The money will still be coursing through the economy regardless, but that isn’t seen in the broken window scenario, because the window hasn’t been broken. In other words, the broken window doesn’t cause economic activity, it merely redirects it, and as Carden says, “on net, society is worse off to the tune of one window.”
The application of this lesson is that we shouldn’t want kids going around throwing rocks through windows. But sometimes rocks do get thrown into windows, and sometimes storms do knock down trees. When this happens, we should acknowledge that the windows and the trees are sunk costs, they aren’t coming back, and we should focus on making the best choice for the future.
In the case of the shopkeeper, the best choice is probably to replace the window. However, in the case of the business owner with the fallen trees, the best choice is probably not to chop up the trees for firewood, but to call a tree removal company.