Sunk cost
In economics and business decision-making, a sunk cost is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, in everyday life, people often take previous expenditures in situations such as repairing a car or house into their future decisions regarding those properties.
Bygones principle
According to classical economics and traditional microeconomic theory, only prospective costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. The only things that matter are the future consequences. Past mistakes are irrelevant. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. They may be described as "water under the bridge," and making decisions on their basis may be described as "crying over spilt milk." In other words, people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions. This is known as the bygones principle or the marginal principle.The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Expected utility theory relies on a property known as cancellation, which says that it is rational in decision-making to disregard any state of the world that yields the same outcome regardless of one's choice. Past decisions—including sunk costs—meet that criterion.
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 instance, if someone is considering pre-ordering movie tickets, but has not actually purchased them yet, the cost remains avoidable.
Both retrospective and prospective costs could be either fixed costs or variable costs. However, many economists consider it a mistake to classify sunk costs as "fixed" or "variable." For example, if a firm sinks $400 million on an enterprise software installation, that cost is "sunk" because it was a one-time expense and cannot be recovered once spent. A "fixed" cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the software. The upfront irretrievable payment for the installation should not be deemed a "fixed" cost, with its cost spread out over time. Sunk costs should be kept separate. The "variable costs" for this project might include data centre power usage, for example.
There are cases in which taking sunk costs into account in decision-making, violating the bygones principle, is rational. For example, for a manager who wishes to be perceived as persevering in the face of adversity and privately holds information about the undesirability of abandoning a project, it may be rational to display the sunk cost effect and persist with the project.
Fallacy effect
The bygones principle does not accord with real-world behavior. Sunk costs do, in fact, influence people's decisions, with people believing that investments justify further expenditures. People demonstrate "a greater tendency to continue an endeavor once an investment in money, effort, or time has been made." This is the sunk cost fallacy, and such behavior may be described as "throwing good money after bad," while refusing to succumb to what may be described as "cutting one's losses".The term "Concorde fallacy" derives from the fact that the British and French governments continued to fund the joint development of the costly Concorde supersonic airplane even after it became apparent that there was no longer an economic case for the aircraft. The British government privately regarded the project as a commercial disaster that should never have been started. However, political and legal issues made it impossible for either government to pull out.
In an everyday example, a person may purchase a ticket to a baseball game and find after several innings that they are not enjoying the game. Their options at this point are:
- Accepting the waste of money on the ticket price and watching the remainder of the game without enjoyment; or
- Accepting the waste of money on the ticket price and leaving to do something else.
Many people, however, would feel obliged to stay for the rest of the game despite not really wanting to, perhaps because they feel that doing otherwise would be wasting the money they spent on the ticket. They may feel they have passed the point of no return. Economists regard this behavior as irrational. It is inefficient because it misallocates resources by taking irrelevant information into account.
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. A second example is research and development costs. Once spent, such costs are sunk and should have no effect on future pricing decisions. So a pharmaceutical company's attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars. However, R&D costs, and the ability to recoup those costs, are a factor in deciding whether to spend the money on R&D or not.
The sunk cost effect may cause cost overrun. In business, an example of sunk costs may be an 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 power plant; the value now is zero because it is incomplete. The plant can be completed for an additional $10 million or abandoned and a different but equally valuable facility built for $5 million. Abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss of the original expenditure—the original sum invested is a sunk cost. If decision-makers are 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 incentives. A decision-maker might make rational decisions according to their incentives, outside of efficiency or profitability. This is considered to be an incentive problem and is distinct from a sunk cost problem.
Sunk costs are distinct from economic losses. For example:
Some research has also noted circumstances where the sunk cost effect is reversed; that is, where individuals appear irrationally eager to write off earlier investments in order to take up a new endeavor.
Plan continuation bias
A related phenomenon is plan continuation bias, also called get-there-itis or press-on-itis, which is an unwise tendency to persist with a plan that is failing.This is a dangerous hazard for ships' captains or aircraft pilots who may stick to a planned course even when it is leading to fatal disaster and they should abort instead. A famous example is the Torrey Canyon oil spill in which a tanker ran aground when its captain persisted with a risky course rather than accepting a delay. It has been a factor in numerous air crashes and an analysis of 279 approach and landing accidents found that it was the fourth most common cause, occurring in 11% of cases. Another analysis of 76 accidents found that it was a contributory factor in 42% of cases.
Projects often suffer cost overruns and delays due to the planning fallacy and related factors including excessive optimism, an unwillingness to admit failure, groupthink and aversion to loss of sunk costs.
Psychological factors
Evidence from behavioral economics suggests that there are at least five specific psychological factors underlying the sunk cost effect:- Loss aversion, whereby the price paid becomes a benchmark for the value, whereas the price paid should be irrelevant.
- Framing effects, a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.
- An overoptimistic probability bias, whereby after an investment the evaluation of one's investment-reaping dividends is increased.
- The requisite of personal responsibility. Sunk cost appears to operate chiefly in those who feel a personal responsibility for the investments that are to be viewed as a sunk cost.
- The desire not to appear wasteful—"One reason why people may wish to throw good money after bad is that to stop investing would constitute an admission that the prior money was wasted."
Experiments have shown that the sunk cost fallacy and loss aversion are common; 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, who collaborated in this area with Amos Tversky, won the Nobel Prize in Economics for his extensive work.