Sunk Costs

by Dual Income No Kids on February 17, 2010 · 3 comments

Hello Folks,

Most people are familiar with the expression “don’t throw good money after bad.” It’s a nice and tidy saying, warning the listener against perpetuating bad decisions, a very rational thought. As humans though, we often act irrationally, under the misguided notion that we are making the right decision. The concept illuminated by that saying is known as “sunk costs”. Sunk costs are transactions that have occurred in the past that are irreversible. For instance, purchasing a Big Mac from McDonalds is an irreversible financial transaction. Although I haven’t tried, I doubt they’d let you return it and get your money back, barring any sort of problem with the food of course. Therefore, any decision regarding that Big Mac occurs independent of the fact that you’ve purchased that food. You’ve already spent the money on it, you can’t get it back. It would be irrational to include the fact that you’ve already spent money on McDonalds in any future decision.

Continuing with the food example, I’m trying to get back into shape, with mixed results at best. One of the irrational decisions that I’ve known myself to make when it comes to dieting is if I eat poorly during an early meal such as breakfast or lunch, I’ll use that fact to justify eating poorly later on in the day at dinner, for example (telling myself that I’ve already screwed up for that day, and I’ll start fresh tomorrow). So, the notion of sunk costs can be used an example of using an irreversible past transaction to justify making a future decision.

The battle between rational and irrational decision making is waged in many areas of economics. One current example that has quite a controversy associated with it is the idea of strategically defaulting, championed by Professor Brent White at the University of Arizona. Many people make the decision to stay in homes that they aren’t able to afford, whereas the rational decision is often to default on their home, thus making the decision which puts them in the best position economically, long term. While that example is more complex than I how I depicted it – most similar debates are – due to the idea of a “social contract” and such, it is another example of how rationality is not always the driving force behind the decisions we make.

Going back to sunk costs, I think the clearest example of this idea can be found in politics, and specifically, the decisions that politicians make. This is tied into the idea of “loss aversion”, the preference held by individuals to minimizing losses as opposed to maximizing gains. In politics, this can be seen in any number of pet projects, advocated for and funded by state, local and federal governments. A politician might promote a program that he or she thinks is a good idea, until that program is implemented and it becomes apparent that it is perhaps inefficient and perhaps potentially incurring devastating future costs. Rather than ignoring the previous investment in that program and allocating future funds where their benefit will be maximized, the politician may attempt to save face, attempting to avoid a total loss, and will continue support a bad program, knowing that future money spent there could be used better somewhere else.

Following this theme, the health care package that is currently being debated in Congress could potentially form an example of the sunk cost fallacy. Members of Congress and their constituents are cognizant of the amount of time that has already been spent developing the comprehensive health care package. If calls to just pass a health care bill start to overwhelm desires to pass the best possible bill, members of Congress who act accordingly will be falling for the sunk cost fallacy. Although there are other issues there of course, the main one being a strong desire to get re-elected.

Irrational decisions can often mask themselves when we start talking about reaching a “point of no return”, where we feel like we’ve already invested too much to turn back. But when that happens, we’d do well to take a step back, examine the decision from a purely rational standpoint, and then make the decision that makes the most sense for us economically.

-Michael

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{ 3 comments… read them below or add one }

1 Edwin February 17, 2010 at 8:36 pm

I was introduced to sunk costs in my business school classes. It's a concept formed to try and get past the psychological barrier that prevents people from making proper decisions.

In a business sense, if a company has spent 1 million on one project but hasn't even started another, some people would have a propensity to finish that project.

Projections could show that first project as costing another 1 million and returning 500,000 and the second project also costing another 1 million but returning 600,000.

Although the second project is clearly more profitable now, some managers may ignore this and continue the first project because they feel the first million spent would be wasted otherwise.

2 Anonymous February 18, 2010 at 8:43 pm

I first grasped, and articulated, the concept as a 14 year-old, but I didn't then know the term "sunk costs."

I was at a really bad movie with a friend, and after about 30 minutes it was clear that it wasn't going to get any better. My friend felt that if we didn't stay, we would have wasted our money. I told him, on the contrary, we've spent our money and will never get it back; now, as a completely unrelated proposition, we had to make a decision as to whether we wanted to sit through another hour or more.

In the end, we compromised: I waited for him at B. Dalton and met him after the movie.

3 Monevator February 20, 2010 at 7:12 am

Considering sunk costs can be liberating, too, of course, especially if you've been toiling away at a blog for a couple of years!

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