Economics Terms A-Z
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Sunk costs are an important concept in economics. A sunk cost is an expense (of money or potentially time) that someone has already paid in exchange for a good or service; sunk costs cannot be recovered. This cost should therefore not feature in any decision making process, but often individuals fall victim to the “sunk cost fallacy” and factor these costs into their decisions anyway. This article will dive into sunk costs and explain how this fallacy reveals our sometimes irrational human nature.
Sunk costs are by definition a past event, as they’re costs that the individual has already incurred and cannot recover. When you buy a good or service, that purchase becomes a sunk cost as soon as you finish the transaction (assuming that warranties and similar agreements don’t exist, in which case the transaction is finished once these “services” expire). Because the money is gone, it shouldn’t matter for any future decision-making.
It’s important to note that sunk costs don’t just have to be monetary expenses. Expenditures of time and effort are also classic examples of sunk costs. For example, if someone starts an engineering degree but realizes they don’t want to become an engineer, the time, effort, and any money spent on the degree become sunk costs for the individual. Ideally, this person should realize they don’t want to be an engineer and choose a degree that will make them better off in the long run, no matter how long they’d been studying engineering.
What is the sunk cost fallacy?
The sunk cost fallacy is when individuals irrationally factor their sunk costs into their current decision-making. This can cause people (or businesses) to choose sub-optimal outcomes that don’t maximize their utility (or profits) – all because of a decision made in the past that can’t be changed.
For example, imagine that you go to a theme park. You buy the weekend pass tickets in advance, and they cover park entrance fees for Saturday and Sunday (assume that they are non-refundable tickets). You spend your Saturday at the park and have a great time – let’s say that you gain 50 units of utility from this.
Unfortunately, on Sunday it is forecasted to rain all day. Rain would ruin your park experience since it’s mostly outdoors and you hate rain. You would gain 0 utility from going to the park in the rain. But you’re an avid movie fan, and know that you could gain 10 units of utility from staying home and seeing a movie, avoiding the rain entirely.
Knowing this, you, being a fully rational economic agent, choose to spend your Sunday not going to the park. You stay home and watch a movie instead. In this scenario, you end up with 50 + 10 = 60 utility for your weekend activities. It was unfortunate that it rained on Sunday, but you assessed your options and made the best of a bad scenario.
But, if you fall prey to the sunk cost fallacy, you might go to the theme park on a rainy day anyway, have a bad day, and come out with less utility than you could have otherwise. This is an irrational decision. Since rain reduces your theme park utility on that day to 0 in this example, your total utility for the weekend ends up being 50 + 0 = 50 if you still go on Sunday. You’d have been better off ignoring your pre-paid Sunday ticket and doing something else instead!
It’s psychologically difficult for most people to cut their losses and move on, causing many to become victims of this fallacy. Ironically, this is due to the loss aversion desire most decision-makers share. Most of us probably imagine that it would be difficult to give up on the pre-bought tickets for the second day, even if the rain was certain to come and ruin the experience. That’s because it feels like we’re losing the Sunday ticket – even though we already lost the money used to pay for it. But most economists would agree that giving up on the park and doing something more enjoyable instead is the right thing to do for a rational, utility-maximizing individual.
It seems odd to watch a movie when the theme park ticket was already paid for – isn’t it a waste if the ticket goes unused? Our psychology often answers “yes” to this question. But, again, the economically correct answer is “no, because you can’t change the weather and your Sunday park ticket is now a sub-optimal usage of your time”. You must make the best of your current situation given the options and tradeoffs you currently face – past decisions should not affect the rational economic agent because they cannot be changed.
Sunk costs in real-world business decisions
Sunk costs don’t just factor into individual decision making, of course. They’re also important in business contexts, and shrewd managers will be on the lookout for the sunk cost fallacy in their decision making.
Consider the market for cameras. Before digital cameras were invented, people relied on film to develop their pictures. These physical rolls of film had to be developed and processed, usually by a company offering film development services. Clearly, when digital cameras were invented, they greatly improved the photo industry. People could instantly develop and view their photographs without needing to waste money and time developing film.
Kodak was once a giant in the camera and film industry. But, in the 1970s a Kodak employee developed the first digital camera and successfully earned Kodak a patent for the technology in 1977. This patent gave Kodak the ability to revolutionize the camera industry and establish itself as a leader in the digital camera market. Instead, Kodak decided to stick with film production and development, as the company already made a lot of money on film. They did not use their digital camera patent until far too late, when other companies had already established themselves as market leaders.
It should have been clear to business leaders at Kodak that digital cameras were the future, and that they could have made massive profits by leveraging their digital camera patent. But instead, Kodak leadership considered the sunk costs – their familiarity with and dependence on film – and decided that they shouldn’t do anything. Despite eventually starting to sell digital cameras, Kodak was too far behind other companies. They never recovered their market share and filed for bankruptcy in 2012.
It’s easy for a manager – and therefore, a business – to refuse to back out of a certain market or give up on a product when a lot of investment has already gone into it, just like Kodak managers did. When time and effort has been put into something, it’s difficult to take another course of action.
Another prime example of the sunk cost fallacy is investment behavior in the stock market. Often, amateur investors believe that a stock will perform well, so they invest their money into the stock. When the stock unexpectedly falls, the amateur investor might still believe that it will do well, and has a desire to “recoup their loss” by waiting until the stock price recovers.
Unfortunately, this might never happen, particularly when a company goes out of business. Rather than admit the mistake and reclaim their money at a loss, the amateur investor loses all of their money. Of course, other factors – like a lack of perfect information, and false hope – factor into this kind of scenario as well. But the sunk cost fallacy contributes to situations like these, and it pays to be aware of the mistake.
For a worthwhile book on sunk costs, look no further than John Sutton’s 1991 Sunk Costs and Market Structure: Price Competition, Advertising and the Evolution of Concentration. In this volume, Sutton uses economic theory alongside econometric evidence to examine the classic assumptions about market structure.
Specifically, he examines the game theory-informed oligopoly models that were then advancing the theory of industrial organization. Sunk costs, along with a few other factors (like the intensity of competition) are an important determinant of market structure, according to Sutton.
Good to Know
This concept also begins to demonstrate how the traditional neoclassical assumptions made in economics are unrealistic. If such a widespread and relatively simple phenomenon has been widely observed, how could individuals be economically rational in every situation?
Indeed, behavioral economics asks the simple question: what if humans (as individuals, but also in groups) fail to live up to these classic economic assumptions? The field is a vibrant one that brings economics and psychology together, seeking to augment economic models with deeper understandings of human behavior.