Sunk costs

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In economics and in business decision-making, sunk costs are costs that have been incurred and which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action, and prospective costs which are costs that will be incurred if an action is taken. In microeconomic theory, only variable costs are relevant to a decision. Economics proposes that a rational actor does not let sunk costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own merits. It is important to note that the decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

For example, when one pre-orders a non-refundable movie ticket, the price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back the money he originally paid.

Contents 1 Description 2 Features characterizing the sunk cost heuristic 2.1 Overly optimistic probability bias 2.2 Requisite of personal responsibility 3 Loss aversion and the sunk cost fallacy 4 The sunk cost dilemma 5 Bygones principle 5.1 Example 6 See also 7 References 8 Further reading

[edit] Description

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The sunk cost is distinct from the economic loss. For example, when a car is purchased, it can subsequently be resold; however, it will certainly not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which should no longer be relevant; it may be used inconsistently in quantitative terms as the original cost or the expected economic loss. It may also be used as shorthand for an error in analysis due to the sunk cost fallacy, non-rational decision-making or, most simply, as irrelevant data.

Economists argue that sunk costs are not taken into account when making rational decisions. In the case of the movie ticket, the ticket buyer can choose between the following two end results:

1. Having paid the price of the ticket and having suffered watching a movie that he does not want to see, or;
2. Having paid the price of the ticket and having used the time to do something more fun.

In either case, the ticket-buyer has "paid the price of the ticket" so that part of the decision should cancel itself out. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the movie at all, regardless of the price, just as if he were to go to a free movie. The economist will suggest that since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.

Sunk costs may cause cost overrun. In business, an example of sunk costs may be investment into a factory or research that now has a lower value or no value whatsoever. For example, $20 million has been spent on building a powerplant; the value at present is zero because it is incomplete (and no sale or recovery is feasible). The plant can be completed for an additional $10 million, or abandoned and a different facility built for $5 million. It should be obvious that abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss on the original expenditure — the original sum invested is a sunk cost. If decision-makers are (economically) irrational, or have the wrong incentives, the completion of the project may be chosen. For example, politicians or managers may have more incentive to avoid the appearance of a total loss. In practice, there is considerable ambiguity and uncertainty in such cases, and decisions may in retrospect appear irrational that were, at the time, reasonable to the economic actors involved and in the context of their own incentives.

Behavioral economics recognizes that sunk costs often affect economic decisions due to loss aversion: the price paid becomes a benchmark for the value, whereas the price paid should be irrelevant. This is considered non-rational behaviour (as rationality is defined by classical economics). Economic experiments have shown that the sunk cost fallacy and loss aversion are common, and hence economic rationality — as assumed by much of economics — is limited. This has enormous implications for finance, economics, and securities markets in particular. Daniel Kahneman won the Nobel Prize in Economics in part for his extensive work in this area with his late collaborator, Amos Tversky.

[edit] Features characterizing the sunk cost heuristic

Two specific features characterizing the sunk cost heuristic worth mentioning are:

1. An overly optimistic probability bias, whereby after an investment the evaluation of one's investment reaping dividends is increased.
2. The requisite of personal responsibility. Sunk cost appears to operate chiefly in those who feel personal responsibility for the investments that are to be viewed as sunk.

[edit] Overly optimistic probability bias

In 1968 Knox and Inkster^[1], in what is perhaps the classic sunk cost experiment, approached 141 horse bettors: 72 of the people had just finished placing a $2.00 bet within the past thirty seconds, and 69 people were about to place a $2.00 bet in the next thirty seconds. Their hypothesis was that people who had just committed themselves to a course of action (betting $2.00) would reduce post-decisional dissonance by believing more strongly than ever that they had picked a winner. Knox and Inkster asked the bettors to rate their horse's chances of winning on a 7 point scale. What they found was that people who were about to place a bet rated the chance that their horse would win at an average of 3.48 which corresponded to a "fair chance of winning" whereas people who had just finished betting gave an average rating of 4.81 which corresponded to a "good chance of winning." Their hypothesis was confirmed - after making a $2.00 commitment, people became more confident their bet would pay off. Knox and Inkster performed an ancillary test on the patrons of the horses themselves and managed (after normalization) to repeat their finding almost identically.

Additional evidence of inflated probability estimations can be found in Arkes and Blumer (1985)^[2] and Arkes & Hutzel (2000)^[3].

[edit] Requisite of personal responsibility

In a study of 96 business students in 1976 Staw and Fox^[4] gave the subjects a choice between making an R&D investment in either an underperforming company department, or in other sections of the hypothetical company. Staw and Fox divided the participants into two groups; a low responsibility condition and a high responsibility condition. In the high responsibility condition the participants were told that they as manager had made an earlier, disappointing R&D investment. In the low responsibility condition, subjects were told that a former manager had made a previous R&D investment in the underperforming division and were given the same profit data as the other group. In both cases subjects were then asked to make a new $20 million investment. There was a significant interaction between assumed responsibility and average investment, with the high responsibility condition averaging $12.97 million and the low condition averaging $9.43 million.

Similar results have been obtained in earlier studies by Staw (1974,1976) and by Arkes and Blumer (1985) ^[2] and Whyte (1986)^[5].

[edit] Loss aversion and the sunk cost fallacy

Many people have strong misgivings about "wasting" resources. This is called "loss aversion". In the above example involving 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 passed the point of no return. This is sometimes called 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".^[6]

This line of thinking, in turn, may reflect a nonstandard measure of utility, which is ultimately subjective and unique to the consumer. A ticket-buyer who purchases a ticket to a bad movie in advance, makes a semi-public commitment to watching it. To leave early is to make this lapse of judgement manifest to strangers, an appearance he may rationally choose to avoid. Alternatively, he may take pride in having recognised the opportunity cost of the alternative use of time.

The idea of sunk costs is often employed when analyzing business decisions. A common example of a sunk cost for a business is the promotion of a brand name. This type of marketing incurs costs that cannot normally be recovered. It is not typically possible to later "demote" one's brand names in exchange for cash.

The sunk cost fallacy is also sometimes known as the "Concorde Effect", referring to the fact that the British and French governments continued to fund the joint development of Concorde even after it became apparent that there was no longer an economic case for the aircraft. The project was regarded privately by the British government as a "commercial disaster" which should never have been started, and was almost cancelled, but political and legal issues ultimately made it impossible for either government to pull out.

[edit] The sunk cost dilemma

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The economic approach that sunk costs should not be considered when decisions are being made can lead to a situation where the sum of a number of good decisions can lead to one big disaster. This dilemma situation can be described using a game theory approach for 1-player games.

The sunk cost dilemma with its sequence of good decisions should not be confused with the sunk cost fallacy, where a misconception of sunk costs can lead to bad decisions.

[edit] Bygones principle

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The Bygones Principle is an economic theory used in business. Economists stress the "extra" or "marginal" costs and benefits of every decision. The idea is to not look backwards when making decisions and stresses the importance of ignoring past costs in future decision-making. The bygones principle states that when making a decision, one should make a hard-headed calculation of the extra costs one will incur and weigh these against its extra advantages. It emphasises the importance of only taking into account the future costs and benefits when making decisions.

[edit] Example

An important example of this is related to nuclear power. In the late 1980s, about two dozen partially complete nuclear power plants dotted the USA landscape. Some had already absorbed billion of dollars of investment but were not yet ready to operate.

One particularly difficult case was the Shoreham plant on Long Island Sound, New York. By 1987 the owner had spent $5.5 billion on bricks, mortar, fuel rods, and interest but the operating license had not been granted. From an economic point of view, the $5.5 billion of past investments should not be weighed in decision making processes.

The bygones principle would state that the $5.5 billion of past cost is irrelevant. From an economic point of view, the only relevant issue concerns future costs and benefits. That is, the economic benefits of the electricity that Shoreham would produce.

The key to observe in making this calculation is that the sunk cost of $5.5 billion is irrelevant to future costs and benefits. Studies indicated that, if the $5.5 billion were ignored, the future costs of the nuclear power plant would be slightly less than the next-best alternative, even though the total cost was far higher than the alternative. A pure economic analysis (ignoring safety issues) would conclude that the most efficient outcome would be to open the Shoreham nuclear power plant.

[edit] See also

• Commitment
• Cost overrun
• Foot in the door
• Irrational escalation
• Prospect theory
• Psychology of previous investment
• Sunk cost dilemma

[edit] References

• Arkes, H. R., and Ayton, P. (1999) "The Sunk Cost and Concorde effects: are humans less rational than lower animals?" Psychological Bulletin 125:591–600.
• Varian, Hal R. Intermediate Microeconomics: A Modern Approach. Fifth Ed. New York, 1999. ISBN 0-393-97830-3
• N. Gregory Mankiw, Principles of Economics, Third Ed. (International Student Edition) page 297. ISBN 0-324-20309-8
• Schaub, Harald (1997) "Sunk Costs, Rationalität und ökonomische Theorie". Schäffer Poeschel, Stuttgart 1997. ISBN 3-7910-1244-4
• Sutton, J. Sunk Costs and Market Structure. The MIT Press, Cambridge, Massachusetts, 1991. ISBN 0-262-19305-1

[edit] Further reading

• Bade, Robin; and Michael Parkin. Foundations of Microeconomics. Addison Wesley Paperback 1st Edition: 2001.
• Samuelson, Paul; and Nordhaus, William. Economics. McGraw-Hill International Editions: 1989.