The Nobel Prize winner and his wine experience

On Monday, Richard Thaler was awarded the Nobel Memorial Prize in Economic Sciences for his work with behavioural economics.

Thaler, who is a professor at the University of Chicago, enjoys golf and fine wine. So, to illustrate behavioural economics, Thaler uses wine and a simple question:

How much would it cost you to drink a bottle of wine that you bought years ago for $50, but is now worth $500?

This example is to reflect how many people confuse two cognitive biases: sunk costs and opportunity costs.

A sunk cost is money you’ve spent already; it’s gone.

An opportunity cost is the price of choosing one course of action over another: in this case, drinking the bottle instead of selling it for $500.

« Most people say it doesn’t cost me anything » said Thaler. « Some people who I cherish even say I actually make money drinking this wine because it only cost me $50. That’s mental accounting » concluded Thaler.

« In all likelihood, some of those collectors who opt to drink their wine would have a difficult time going out and paying $500 for that same bottle and drinking it with dinner, though that is exactly what they are doing when they drink it today. They prefer to think that drinking it is a deal because they paid $50 for it years ago » explained Thaler.

Thaler’s point is that people aren’t rational when it comes to money … or wine.