What this lesson teaches
I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.
Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms
Make a guess
You paid $20 for a movie ticket. After 30 minutes, you are bored. Your friend says, "Stay, or the $20 is wasted." What is the best economic advice?
- Stay, because leaving would waste the $20 you paid.
- Stay only if the ticket was expensive.
- Leave if the rest is not worth your time.
Show the answer
Leave if the rest is not worth your time.
The $20 is a sunk cost: you cannot get it back either way. Only future costs and benefits should affect the decision.
Consumers do not always act rationally: sunk costs, loss aversion and salience shape their choices, and firms use this.
The standard model assumes consumers weigh costs and benefits carefully. In reality, cognitive biases affect decisions. The syllabus names three.
Sunk cost fallacy: letting money already spent, which cannot be recovered, affect a new decision. For example, staying through a bad movie because you paid for the ticket.
Loss aversion: people feel a loss more strongly than a gain of the same size. Firms frame offers as 'don't lose your discount' rather than 'get a discount'.
Salience: people pay more attention to information that stands out. A low headline price in large print draws attention away from extra charges. Singapore's price transparency guidelines require unavoidable charges to be included in the headline price for this reason.
- Sunk cost fallacy
- Letting past, unrecoverable spending affect a new choice.
- Loss aversion
- Losses feel bigger than equal gains.
- Salience
- Attention goes to what stands out.
Worked example: Three ways a gym directs attention
A gym member has paid a non-refundable joining fee. The gym sends three messages.
- 'Buy personal training so your joining fee is not wasted': plays on the sunk cost fallacy.
- 'Renew now or lose your member rate': plays on loss aversion.
- 'Only $1 a day!' in large print, with fees in small print: uses salience.
Watch out for this
Loss aversion means people dislike spending money.
It means losses feel bigger than equal gains, relative to what people already have or expect.
Check your understanding
A shopper keeps using a service they dislike because they already paid a non-refundable fee. Which bias is this?
- Loss aversion: losing the fee feels worse than gaining a better service.
- Salience: the fee is the most noticeable cost, so it drives the choice.
- The sunk cost fallacy.
Show the answer
The sunk cost fallacy.
Right. The fee is gone whatever they do, so it should not affect the decision.