Sunk cost

From Wikipedia, the free encyclopedia

In economics and in business decision-making, sunk costs are costs that have already 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. 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. 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.

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, there are two possible end results. The ticker-buyer will have:

1. Paid the price of the ticket and suffered watching a movie that he does not want to see, or;
2. Paid the price of the ticket and 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 latter option only involves suffering in one way (spent money), while the former involves suffering in two (spent money plus wasted time), the latter 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.

Behavioural 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 partner, Amos Tversky.

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.

Overly optimistic probability bias

Knox and Inkster (1968) , in what is perhaps the classic sunk cost experiment, approached 141 horse bettors. 72 people who had just finished placing a $2.00 bet within the past thirty seconds, and 69 people who 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) and Arkes & Hutzel (2000).

Requisite of personal responsibility

In a study of 96 business students Staw and Fox (1977) 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) and Whyte (1986).

Loss aversion and the sunk cost fallacy

Many people have strong misgivings about "wasting" resources. This is called "loss aversion". Many people, for example, would feel obligated 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.

This line of thinking, in turn, may reflect a nonstandard measure of utility, which is ultimately subjective and unique to the consumer. When a ticket-buyer purchases a ticket in advance to a bad movie, he has still made a semi-public commitment to watching it. The ticket-buyer may "save face" by sticking it out, a satisfaction he cannot draw if he leaves. To leave early is to make his lapse of judgment manifest to strangers, an appearance he may rationally choose to avoid. He may, in fact, find some amusement in how bad the movie turned out to be, and take pride that he recognised it to be bad. Or he may feel qualified to criticize the movie in front of his peers. Either way, this mitigates the decision to view the movie, not the decision to purchase the ticket. Additionally, choosing to still go to the movie forgoes to 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 (except perhaps as an exit strategy from a market). Decisions about future investments, sales or more advertising should be made based on future possibilities, not biased by the recent large investment in the advertising that the company made last year (or even last week).

The sunk cost fallacy is also sometimes known as the "Concorde Effect", referring to the fact that the British and French government 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.

By deliberately using the tactic of incurring sunk costs beyond the point of no return, economic actors may get ventures going that otherwise would not have. In his autobiography, film director Elia Kazan explains how he repeatedly used the tactic of sunk costs to get his films started: "My tactic was one familiar to directors ...: to get the work rolling, involve actors contractually, build sets, collect props and costumes, expose negative, and so get the studio in deep. Once money in some significant amount had been spent, it would be difficult for [the studio head] to do anything except scream and holler. If he suspended a film that had been shooting for a few weeks, he'd be in for an irretrievable loss, not only of money but of 'face.' The thing to do was get the film going" (pp. 412-13). The same tactic has been used for the construction of bridges, tunnels, and other infrastructure. Very few partially built bridges exist, because once construction has started sunk costs are too high to revert the decision and stop again. The sunk cost tactic often causes cost overrun.

The Sunk cost dilemma

The economic approach that sunk costs should not be considered when decision 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.

See also

• Prospect theory
• Commitment
• Foot in the door
• cost overrun
• Sunk cost dilemma

References

• Arkes, Hal & Blumer, Catherine. (1985) "The Psychology of Sunk Cost" Organizational Behavior and Human Decision Process 35, 124-140
• 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.
• Arkes, Hal & Hutzel, Laura. (2000) "The Role of Probability of Success Estimates in the Sunk Cost Effect" Journal of Behavioural Decision Making Volume 13, Issue 3 , Pages 295 – 306
• Varian, Hal R. Intermediate Microeconomics: A Modern Approach. Fifth Ed. New York, 1999. ISBN 0-393-97830-3
• Knox & Inkster. (1968) "Postdecision dissonance at post time" Journal of Personality and Social Psychology 8, 319-323
• 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 3-7919-1244-4
• Staw, Barry. (1976) "Knee Deep in the Big Muddy" Organizational Behavior and Human Decision Process 35, 124-140
• Sutton, J. Sunk Costs and Market Structure. The MIT Press, Cambridge, Massachusetts, 1991. ISBN 0-262-19305-1
• Whyte, Glen. (1986) "Escalating Commitment to a Course of Action: A Reinterpretation" Academy of Management Review Vol. 16, p. 27-44