Simplifying the Sunk Cost Fallacy

What is a Sunk Cost?

A sunk cost refers to a cost that has already been incurred and which cannot be recovered by any means in the future. A sunk cost varies from the potential costs that a company may face, such as decisions about the cost of purchasing tools for production, etc. An example of the sunk cost would be, suppose you buy a ticket of a movie for Rs 750 but then later you realize that you have an important assignment due on the same night. The Rs 750 already spent - the sunk cost - shouldn’t be considered when deciding whether the assignment should be completed or not because the cost of a movie ticket (a sunk cost) is already incurred and is irretrievable. The only thing that should matter is the expected future returns that one will render after the completion of a particular project/work/investment. If completing an assignment is comparatively fruitful then the movie ticket cost shouldn’t be considered.

Behavioral economics says that the sunk costs should not be considered while taking future decisions because the cost will remain the same regardless of the outcome of a decision. The reason economic analysis ignores sunk costs is that by doing so, it prevents decision-makers from throwing good money after bad when they are stuck in an unprofitable project. It is often the case that heavy initial investment in a poor project results in a temptation to spend more money on the project in the hope of recovering the sunk cost or preventing embarrassment. Economics tries to solve this problem by focusing only on future costs and returns.

The fallacy of “Sunk Cost”

The sunk cost fallacy or sunk cost effect is an effect manifested in a greater tendency to continue an endeavor once an investment in money, effort, or the time has been made. It describes a human behavioral tendency to follow through on an objective or project even if the current costs outweigh the benefits. In simple words, people are more likely to make use of something they have already paid a lot for. Sunk cost fallacies are really dangerous and in business, it can even cost a business to face a greater financial crisis.

For example, suppose you have invested 1 crore Rupees in research for developing an innovative car but eventually you realize it won’t fetch market consumer demand. It would be more rational to write off such sunk costs rather than wasting money on developing something which will never make a profit. Instead, humans are likely to invest more in these so-called failed projects because they have the expectations that they will at least get "something out of this".

What drives this Human Behaviour?

Many economists and analysts started observing this phenomenon in individual decision-making in the late 1970s and gradually, extensive research was done on the sunk cost effect. The basic sunk cost finding that people will throw good money after bad appears to be well described by prospect theory (D. Kahneman & A. Tversky, 1979, Econometrica). Richard Thaler is well known for his work on the Sunk Cost effect and his explanation is based on the prospect theory. So what does the prospect theory talk about?

The Prospect theory: - The prospect theory explains why people make such fallacies. It says that people make decisions based on the prospects of a decision rather than on the final outcome. Individual decisions are often influenced by perceived gains and are not evaluated on the basis of final outcomes - leading to sunk cost fallacies.

Fig: The Value Function of Prospect Theory (Kahneman and Tversky, 1979)

Self-Justification theory is yet another famous theory that helps to understand the Sunk Cost fallacy. This theory was developed in the 1990s.

Self-Justification theory: - On the other hand, Self-Justification theory suggests that humans tend to justify their prior behavior, refuse to admit that they have made a wrong decision regarding a particular action or project, which then essentially puts them in a "sunk cost trap".

The famous example of Concorde Aircraft

The Sunk cost fallacy is also known as the Concorde fallacy. Launched in 1976, Concorde was a supersonic passenger jet - a joint project between the French and British government. After a period of significant investment, it became clear that the project was likely to be a bad financial investment. Costs were too high and revenue limited. Both governments continued funding the project despite knowing that there was no economic sense for the aircraft. This resulted in huge financial losses, the governments should have simply written off the sunk costs - accepting initial financial losses. Although it is true that there were political reasons involved which kept both governments to continue this project. The primary lesson was that any decision should not be based on what has already been spent. The Concorde partners learned this lesson 27 years later, costing too much of taxpayers’ money.

The Economics of Love

Falling prey to the sunk cost fallacy is a psychological trap, but have you ever wondered that the fallacy can also explain why people are in “unhappy” relationships? Yes, romantic relationships are classic examples of this fallacy and it explains why it is harder for couples to break up in which they have already invested time, effort, and resources. Prior investments in romantic relationships in terms of time, effort, or money make individuals more prone to stay and invest more in a toxic relationship (to keep it going) in which they are unhappy.

People hung on to toxic relationships thinking "oh, I can’t leave him, it’s been x years we have been together and I have put in so much my time and effort". Despite the clear signs, couples start doing things to support that fragile bad relationship and make it look good to others. If you’re in such a relationship, please introspect before it’s too late. According to behavioral economists and psychologists, in such situations - a rational decision would be to end the relationship, regardless of any prior investments you have made into it. They also suggest that approaching mental health experts could help to mitigate the post-breakup trauma.

Sunk Costs and the Poor people

Esther Duflo and Abhijit Banerjee in their book ‘Poor Economics’ use the concept of “psychological sunk cost” to explain why the poor people in developing countries tend to spend more on expensive healthcare from private doctors rather than getting it for free from government providers.  They say humans have a tendency to judge the quality of a product or service by its price. Poor people consider government healthcare as insignificant precisely because they are cheap and they are more likely to make use of private healthcare because they have paid a lot for it. Of course, this explanation doesn’t make complete sense and thus they have highlighted other factors which drive such human behavior - such as high absenteeism, low motivation among government health providers, under-diagnosing patients, and so on. Regardless, the psychology of sunk cost still plays a major role in driving this behavior in poor people.

Sunk Cost Dilemma in investment

The Sunk Cost dilemma is a situation of intense confusion in which an individual or a firm decides whether to proceed with the venture in which he/she has invested money and time or to stop because the ideal outcome of the venture has not been accomplished or because the project has a dark future. Let’s see an example of such a dilemma. This generally happens when individuals forcefully purchase risky stocks (or assets) - whenever they have faced any significant losses in the past, just to “equal the initial investment” on those losses. The dilemma is whether they should sell their loss-making stocks or should they keep purchasing risky stocks to recover the losses. The better action would be to pick those stocks that can give you the most ideal returns and not investing in some random junk assets which carry a lot of risk with them

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