No, I'm not talking about their employment. We've all grown up with the idea that "quitting" or "giving up" is something bad that only losers do. But I think we could all learn from some basic economic principles that quitting is often the smartest thing you can do.
I came across the idea for today's post with two seemingly unrelated pieces of news. Watch now as I entwine them together before your very eyes! First, on NPR's Marketplace today, Freakonomics team member Stephen Dubner narrated a fascinating piece on the virtues of quitting (listen to it as a podcast here):
One upside of quitting is avoiding [agonizing over] “sunk costs,” the time and effort you’ve put into something that makes it difficult to move on.
That quote is a bit misleading, because sunk costs are, by definition, impossible to avoid -- thus the part in brackets is mine. The concept of sunk costs is very important to economic theory. What's important to remember about them is that both individuals and corporations often fall prey to becoming emotionally invested in "assets" that involve a lot of sunk costs, and we refer to this as the Sunk Cost Fallacy. In individuals, classic examples are that we rarely walk out of movies that suck (having paid for the ticket), we often finish reading books that we don't like ("I bought this book, dammit!"), and we often refuse to sell bad stocks that have fallen sharply since we bought them. The fallacy, of course, is that watching the movie (or finishing the book) does not get you your money back, and holding on to the stock (if it is a bad one) will not recover your losses. And, in fact, doing these things is actually incurring an opportunity cost (you could watch a better movie, read a better book, or buy a better stock instead, and you are foregoing that opportunity!). For corporations, the sunk cost fallacy often rears its ugly head in more insiduous ways.
Let's take the example of an MRI exam, which is a pretty expensive procedure because it involves a very expensive machine. So, doctors are sometimes reluctant to prescribe MRI exams because they are "expensive". But hald on a minute -- if a doctor does fewer MRI exams does he have substantially lower costs than a doctor who does lots of MRI exams? Of course not, because both doctors had to buy the MRI machine anyway. The cost of the machine is a sunk cost -- once you have purchased the machine, each MRI exam costs you basically just some electricity and the technicians time. The cost of the machine no longer really reflects the "cost" of performing an MRI exam, even though a hospital's accounting department might see things differently, because you don't get any refund on that purchase by not using the MRI machine.
Or let's examine the example of a very unprofitable division at a large corporation. Billions of dollars went into this division and it is still losing money. Should the corporation shut down the division? "WHAT!? We've spent billions! We can't shut this down before we recover our money!!" This is surprisingly commonplace at many large corporations and is a classic example of the Sunk Cost Fallacy. The logic is faulty for several reasons: 1) further investment does not "get back" any of your sunk costs, 2) the division is losing money, and running a division that loses money will, by definition, never make a profit, and 3) if you were to invest the money in some other manner and make billions of dollars, you've still earned billions of dollars -- there's no reason you need to earn your billions from this division. By not shutting the division down, you are incurring an opportunity cost.
Whew. Thanks for those of you who didn't just yell "TL;DR" and are still with me. So, what's the second piece of news? I actually heard this on twitter from many sources but let's quote espn:
Uh. That's....fascinating. Oh, and by the way, this is for the 2012-2013 season. You're thinking "Dude, wtf?" Actually, I think it's great timing from the Timberwolves, because I can't think of a better example of the sunk cost fallacy as it applies to the NBA! To see why, let's take a look at these players performances:
Per48 Comparison of raw stats
As we can see, Johnson, Ellington and Hayward were very bad NBA players in 2010. They combined to actually lose their teams 3.5 games last year. Relative to other guards, Ellington was below-average in points, shooting, rebounding, assists, blocks, steals, and free throw attempts (in many cases, badly below-average) and was only average with turnovers and personal fouls. Relative to other forwards, Hayward was sub-par with respect to points, shooting (his 35.7% is pretty embarrassing for a forward), rebounds, steals and fouls, while Johnson fared poorly in every single category except assists, where he's barely above average. In other words, these players actually have had negative value in the NBA so far (follow the links to each player's page to see how they compare to average players at their positions). Why would a team invest even the league minimum in such players?
The answer is simple: These players have already earned millions! Not only that, but Johnson was the 5th pick in the draft! A lot of work went into picking him! If the Timberwolves did not pick up these options, those players would become free agents who couls sign with any other team, and Minnesota would get "nothing" in return for that investment! I'm using too many damn exclamation points! In fairness to Minnesota, I would not be surprised if nearly every NBA team's management has thoughts like these when it makes these decisions, so just this once, I'm not picking on David Kahn alone. This is the sunk cost fallacy in action, ladies and gentleman:
- The $8 million or so that Minnesota is spending on these players in 2012-13 will not recover any of the many millions that were already invested in them
- Even if the timberwolves manage to trade these assets, the return will have to exceed whatever they are spending on keeping the assets just to break even. Given the quality of these players, it is very hard to imagine that the timberwolves couldn't just spend the same amount in 2012-2013 to get a player or players of equal replacement value
But, somehow, if the team signs a player like Ellington, then later trades Ellington for some other asset, this is far more emotionally satisfying than if the team had simply bought that asset outright with the money they could have saved by not paying Ellington in the first place, because the trade scenario feels a lot more like "recouping our losses." In fact, however, the Timberwolves are simply throwing good money after bad. Many will argue that Wes Johnson's pick-up was a "no-brainer" because of his "potential". After all, he was the 5th pick in the lottery! Two words: SUNK. COSTS. Especially with the details of the CBA being uncertain, which will be the better "asset" in the summer of 2012: A) a few million dollars or B) a very bad player under contract for a few million dollars? That should not be a hard question to answer. The Timberwolves should have clearly just "given up" on these players for 2012-13.