Question

The Fallacy of Using Historic Costs

Or there’s no point crying over spilt milk

‘What’s done is done.’

‘Write it off to experience.’

‘You might as well make the best of a bad job.’

These familiar sayings are all everyday examples of a simple fact of life: once something has happened, you cannot change the past. You have to take things as they are now.

If you fall over and break your leg, there is little point in saying, ‘If only I hadn’t done that, I could have gone on that skiing holiday; I could have taken part in that race; I could have done so many other things (sigh).’ Wishing things were different won’t change history. You have to manage as well as you can with your broken leg.

It is the same for a firm. Once it has purchased some inputs, it is no good then wishing it hadn’t. It has to accept that it has now got them and make the best decisions about what to do with them.

Take a simple example. The local greengrocer in early December decides to buy 100 Christmas trees for £20 each. At the time of purchase, this represents an opportunity cost of £20 each, since the £20 could have been spent on something else. The greengrocer estimates that there is enough local demand to sell all 100 trees at £30 each, thereby making a reasonable profit (even after allowing for handling costs).

But the estimate turns out to be wrong. On 23 December there are still 50 trees unsold. What should be done? At this stage the £20 that was paid for the trees is irrelevant. It is a historic cost. It cannot be recouped: the trees cannot be sold back to the wholesaler!

In fact, the opportunity cost is now zero. It might even be negative if the greengrocer has to pay to dispose of any unsold trees. It might, therefore, be worth selling the trees at £20, £10 or even £1. Last thing on Christmas Eve it might even be worth giving away any unsold trees.

Question

Why is the best price to charge for the unsold trees the one at which the price elasticity of demand equals –1? (Assume no disposal costs.)

Answer 1

The greengrocer finds that 50 trees are still unsold. At this stage, it can't reverse the decision of purchasing these trees earlier. It is like a sunk cost, or a historic cost. The best strategy now is that of minimizing losses.

Now, it would be ideal if each tree could be sold for £20 or more. However, it is quite possible that the greengrocer may have to give them away for free - or even incur costs on disposing the unsold trees.

The best price to charge for the unsold trees is the one at which price elasticity of demand is (-1). This indicates unitary elasticity of demand. A 1% increase in price will lead to a 1% decrease in quantity demanded. Or conversely, if price is decreased by 1%, quantity demanded increases by 1%.

At this price, it will be highly probable to clear out the unsold stock. It serves as a very useful reference point. The greengrocer will know that even if a 1% discount is given, sales will rise.

This price point will enable the greengrocer to figure out the ideal discount rate. For example, if he or she gives out too large a discount initially, it could mean more losses.

By knowing the point where price elasticity of demand is (-1), the greengrocer will be able to figure out the maximum willingness to pay for the marginal consumer.

With every tree sold, the greengrocer may need to offer a slightly higher discount.

In other words, the greengrocer will be able to clear out the stock with minimal losses (by providing an optimal discount on the trees, as per the type of consumer).