Question

In mid-2009, the Obama administration announced it would cancel orders for a new fleet of presidential helicopters. About \(\$ 3\) billion had already been spent on developing the helicopters, which had special protective and telecommunications features. But another \(\$ 8\) billion would have been needed to complete the project and deliver the fleet. The administration suggested it might look for a less expensive design and start from scratch. Some media commentators criticized the decision, arguing that cancelling the project would mean wasting the \(\$ 3\) billion already spent. a. Suppose that starting from scratch on a new proposal that would be just as good as the original would cost a total of \(\$ 5\) billion from beginning to end. Which would be the wiser choice sticking with the original or starting from scratch? Why? b. Would your answer change if the new proposal would cost a total of \(\$ 10\) billion? Why or why not?

Short answer

a. The wiser choice would be to start from scratch as it would cost \$6 billion less than completing the original project, even though \$3 billion has already been spent. b. The wiser choice would still be to start from scratch as it would be \$1 billion cheaper, the \$3 billion spent previously are a sunk cost and should not affect future decision making.

Step-by-step solution

Calculate total costs

First, calculate the total costs for each option. For the original project, this includes the sunk cost of \$3 billion, plus the remaining cost to complete it, which is \$8 billion. So the total cost for the original project will be \$3 billion + \$8 billion = \$11 billion. For the new proposal, the total cost will be \$5 billion as given.

Comparison for part a

Compare the total cost of the original project (\$11 billion) with the total cost of the new proposal (\$5 billion). It's clear that \$5 billion < \$11 billion, so the new proposal is the less expensive option.

Answer for part a

Given the calculations, it would be wiser to start from scratch because it would cost \$6 billion less than completing the original project, even though it means accepting that the \$3 billion spent on the original design is a sunk cost.

Comparison for part b

Now suppose the cost of the new proposal has risen to \$10 billion. Compare this with the total cost of the original project (\$11 billion). It's still true that \$10 billion < \$11 billion, so even with this increased cost, the new proposal is less expensive.

Answer for part b

Even at \$10 billion, the new proposal is still the less expensive option by \$1 billion, so it remains the wiser choice. The fact that the \$3 billion sunk cost on the original design cannot be recovered does not make the original design a better choice.

Key concepts

Economic Decision Making

In the realm of economics, decision making is a vital process that involves evaluating various options and choosing the one that offers the greatest benefit for the least cost. This process is crucial in government and business contexts, where the allocation of large sums of money must be justified with sound reasoning. For instance, in our example involving the Obama administration's decision to halt a costly helicopter project, a critical aspect of economic decision making comes into play.

Decision makers must disregard sunk costs, which are past expenses that cannot be recovered, and focus on future costs and benefits. This aligns with a rational approach, known as 'marginal thinking', which emphasizes that only additional, or marginal, costs and benefits should inform decisions. This prevents the common mistake of 'throwing good money after bad' – a phrase cautioning against investing more in a losing proposition simply because you've already invested. To ensure decisions are made rationally, key economic principles like opportunity cost and cost-benefit analysis are employed to assess the trade-offs and net gains associated with different paths.

Opportunity Cost

Opportunity cost is an essential concept in economics that refers to the next best alternative foregone when making a choice. It encapsulates the idea of trade-offs, allowing individuals and entities to understand what is sacrificed when selecting one option over another. This helps in determining the real cost of the decision. For the presidential helicopter situation, the opportunity cost of sticking with the original fleet instead of starting from scratch would be the benefits that could have been realized with the saved funds.

By considering opportunity cost, decision makers are compelled to think critically about the utility of each potential decision, moving beyond mere monetary cost. They examine what could be attained by using resources differently - for example, the alternative public projects or improvements that might be funded with the money saved by cancelling the helicopter project. Understanding opportunity costs supports more holistic and efficient economic decision making, assuring that resources are used in a way that delivers the most substantial possible benefit.

Cost-Benefit Analysis

Cost-benefit analysis is a systematic approach to calculating the strengths and weaknesses of alternatives. It is used to ascertain the best approach to achieve benefits while preserving savings. It involves comparing the projected balances of costs and benefits over time, translating all aspects into monetary terms for better comparability.

Applying cost-benefit analysis to the helicopter scenario involves quantifying all advantages (benefits) and disadvantages (costs) of continuing with the original project against starting from scratch. This helps to visualize not only the financial aspect but also intangibles like time, efficiency, and security enhancements. The analysis revealed that the new proposal, even with its costs, represents a better financial decision than pouring more funds into the original plan. Keeping in mind that sunk costs should not affect the decision-making process, cost-benefit analysis serves as an objective tool to guide public officials and business leaders towards economically sound choices.