by Tim Harding
In economics and business decision-making, a sunk cost is a retrospective (past) cost that has already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken.
In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that economic actors should not let sunk costs influence their decisions. Doing so would not be rationally assessing a decision exclusively on its own merits.
On the other hand, evidence from behavioral economics suggests this theory fails to predict real-world behavior. Sunk costs do, in fact, influence actors’ decisions because humans are prone to loss aversion and framing effects. In light of such cognitive quirks, it is unsurprising that people frequently fail to behave in ways that economists deem rational.
Sunk costs should not affect the rational decision-maker’s best choice. However, until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes. For example, if one is considering preordering movie tickets, but has not actually purchased them yet, the cost remains avoidable. If the price of the tickets rises to an amount that requires him to pay more than the value he places on them, he should figure the change in prospective cost into the decision-making and re-evaluate his decision.
Many people have strong misgivings about ‘wasting’ resources (loss aversion). Continuing with the movie ticket analogy, after purchasing a non-refundable movie ticket, many people, for example, would feel obliged to go to the movie despite not really wanting to, because doing otherwise would be wasting the ticket price – they feel they have passed the point of no return. Similarly, some people will not walk out of a movie they dislike, because they do not want to ‘waste’ the money they have already paid and cannot recover i.e. the sunk cost. This is despite the fact that if they walk out of the movie, they could spend the time doing something else that they much prefer.
Another common instance of this behaviour is the reluctance to sell underperforming company shares (stocks) for fear of wasting one’s original investment; when it would make better sense to sell the shares and use the money to buy some other shares that are more likely to perform better.
This behaviour referred to as the sunk cost fallacy. Economists would label this behavior ‘irrational‘: it is inefficient because it misallocates resources by depending on information that is irrelevant to the decision being made. Colloquially, this is known as ‘throwing good money after bad’. It could also be described as a form of preference failure i.e. not acting in one’s own best interests.
If you find the information on this blog useful, you might like to consider making a donation.