Sunk cost

A sunk cost is a cost that you incurred in the past (i.e. ‘a cost that is sunk into it’) and which cannot be recovered. Because we cannot recover such costs, they should not be taken into consideration when making (rational) decisions. In such cases, only future costs should matter.

An example of a sunk cost

Let’s consider the following simple example to clarify the concept of  a sunk cost. Suppose we bought (non-refundable) cinema tickets to watch a particular movie. However, we realize that we actually dislike the plot and would prefer not to see the movie. In that case, we can choose between either of the two following scenarios:

  1. Having bought the tickets we can still go and watch the movie we dislike
  2. Having bought the ticket we can decide not to go. Instead, we use the time to do something more fun

In both cases we’ve already bought the tickets and we cannot recover the money, as the tickets are non-refundable. Hence, that part of the scenario should no longer affect our choice. The decision whether or not to go to the cinema to see the movie should only depend on whether we still want to see the movie. This is because there’s also an opportunity cost to watching the movie. It’s clearly better that we spend our time on something fun, instead of watching a movie we dislike.

Clearly, if we want to behave rationally, we should therefore choose the second scenario. However, most people will feel obliged to go and see the movie. This is because people focus on what they will lose rather than the gains. In other words, although the costs cannot be recovered and nothing is lost by not going, people still feel as if they are losing the money spent. Instead, people should focus on the gains of not going to the movie they dislike; time that they can spend on something else.

The above behavior can be explained by the fact that we exhibit loss aversion, i.e. we don’t want to waste resources. This causes us to opt for scenario 1.

Let’s consider another example in business. Suppose you’ve paid a consultant a $1000 to look into a new business idea. The consultant advises you not to move forward with it because the outlook for the market is bad. However, if you don’t move forward, the money paid to the consultant will be a waste. So you might be tempted to move forward to ‘avoid the loss of the $1000. This is a clear example of ‘throwing good money after bad’ and the sunk cost fallacy.

Summary

Although sunk costs should be ignored, people still tend to take them into account when making decisions. To avoid falling into the sunk cost fallacy, we should try to focus on what we stand to gain from taking action.

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