Richard Thaler won the Nobel Memorial Prize in Economic Sciences for his work in behavioral economics. A question he asked about wine illustrates his field.
Behavioral economics is the field that studies the overlap of human behavior and economic principles — or why we behave like we do with money.
Thaler is famous for his work, and is the author of the widely read book "Nudge: Improving Decisions about Health, Wealth, and Happiness," co-authored with Harvard professor Cass R. Sunstein.
Outside of economics, Thaler, who is a professor at the University of Chicago, enjoys golf and fine wine, reports Business Insider's Will Martin.
So it's perhaps unsurprising that Thaler asked New York Times Wealth Matters columnist Paul Sullivan a question about wine to illustrate behavioral economics in Sullivan's book, "The Thin Green Line: The Money Secrets of The Super Wealthy."
Before you answer, pretend you're a wine collector, or at least someone who buys bottles and keeps them around for a while before drinking.
The question is:
How much would it cost you to drink a bottle of wine that you bought years ago for $50, but is now worth $500?
(Pause for your answer.)
The answer has less to do with wine than it does with economics.
In fact, it's an illustration of how many people confuse two cognitive biases: sunk costs and opportunity costs.
A sunk cost is money that you've spent already. It's gone, and nothing you do now is going to change that. You have to write it off. In this case, the $50 you spent to buy the bottle in the first place is a sunk cost.
An opportunity cost is the price of choosing one course of action over another — in this case, choosing to drink the bottle instead of selling it for $500, or even keeping it and selling it for more money in the future.
The correct answer to the question is that it costs you $500 to drink the bottle, because you're choosing to enjoy it instead of sell it.
"Most people say it doesn't cost me anything," Thaler explains to Sullivan. "Some people who I cherish even say I actually make money drinking this wine because it only cost me $50. That's mental accounting."
Sullivan explains further:
"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."
Sullivan's point is that people aren't rational when it comes to money. We buy too much and save too little, because the average person doesn't think about money fully rationally, like an economist might.
We aren't all going to become overnight economists — or fully rational beings, for that matter — but keeping the cognitive biases that influence your financial decisions in mind could help you make better ones.