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Sunk cost

From Academic Kids

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 incremental costs, which are the costs that will change due to the proposed course of action. In microeconomic theory, only incremental costs are relevant to a decision. If we let sunk costs influence our decisions, we will not be assessing a proposal exclusively on its own merits.

For example, when you pre-order a movie ticket, the price of the ticket becomes a sunk cost. Even if you decide that you'd rather not go to the movie, there is no way to get back the money you originally paid and you have a sunk cost on your hands. This assumes, of course, that you can't simply return the movie ticket for a refund, and that the odds that you are able to resell the ticket are essentially zero.

Sometimes only part of the price of a purchase ends up being a sunk cost. For example, when you purchase a car, you will be able to resell it later, though you will almost certainly not fetch the original price for it. In this case, your sunk cost with respect to the car at any given time is the difference between how much you originally paid and how much you could sell it for now.

Economists argue that, if you are rational, you will not take sunk costs into account when making decisions. In the case of the movie ticket, there are two possible end results. You will either have:

  1. Paid the price of the ticket and suffered watching a movie that you do not want to see, or;
  2. Paid the price of the ticket and used the time to do something more fun.

In either case, you have "paid the price of the ticket" so that part of the decision should cancel itself out. If you regret buying the ticket because you do not think the movie is worth the money then your current decision should be based on whether you want to see the movie at all, regardless of what you have paid for it - just like deciding whether you want to go to a free movie. The economist will suggest that since the latter option only involves you suffering in one way (spent money), while the former involves you suffering in two (spent money plus wasted time), the latter is obviously preferable.

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 business 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. If you buy a ticket in advance to a movie you find is bad, you have still made a semi-public commitment to watching it. You may feel that you "save face" by sticking it out, a satisfaction you cannot draw if you leave. To leave early is to make your lapse of judgment manifest to strangers, an appearance you may rationally choose to avoid. You may in fact find some amusement in how bad the movie turned out to be, and take pride that you recognise it to be bad.

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).

References

  • Hickman, J. Bush in Baghdad. On Line Opinion: Australia's E-Journal of Social and Political Debate. Article (http://www.onlineopinion.com.au/view.asp?article=1009)
  • Sutton, J. Sunk Costs and Market Structure. The MIT Press, Cambridge, Massachusetts, 1991. ISBN 0262193051
  • Varian, Hal R. Intermediate Microeconomics: A Modern Approach. Fifth Ed. New York, 1999. ISBN 0393978303
  • N. Gregory Mankiw, Principles of Economics, Third Ed. (International Student Edition) page 297. ISBN 0-324-20309-8de:Sunk cost

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