Sunk Costs: The Big Misconception About Most Investments

Imagine you place a $5,000 non-refundable deposit on a venue for your wedding, but later decide to call everything off. What would be the cost of canceling? If you think it’s $5,000, you fell for what’s known as the sunk cost fallacy — a common cognitive bias. 

From an economic perspective, it’s what we give up going forward with the decision to cancel and does not include the cost of the venue rental, because no matter whether we get married or not we’re out the $5,000. That choice has already been made and is irreversible. It has become what we call a sunk cost. Because sunk costs cannot be changed going forward, they are not relevant to the next decision.

the full story
Introduction to Sunk Cost

Jimmy sells his catch at the local market. He knows that he can sell only fresh fish, so he throws the bad ones away, regardless of the time it takes him to find, catch, and clean the fish.

Jimmy knows that if he were to sell spoiled goods, his customers would not return. So, instead of crying over stale fish, he considers them as sunk costs and sells what customers actually want. In his free time, Jimmy isn’t’ that rational

jimmy’s story
Jimmy story

Unlike fish that don’t go to the movies, Jimmy does. He buys himself a ticket for the afternoon show. But it turns out that a few hours before the film starts, his friends want to meet up to play football, Jimmy’s favorite sport. Since he has already spent the money on the ticket, he declines the invitation. According to sunk costs theory, he shouldn’t have — the money he spent on the tickets is already gone, and he won’t get it back by watching the movie. What matters is that he has a good time.

sunk cost fallacy
Sunk cost fallacy

Jimmy falls for the so-called sunk cost fallacy, the strong natural fear of losing what we already own and the tendency of our brain to treasure all the things we possess.

A more famous example of the fallacy is the Concorde — the supersonic passenger plane. Building the aircraft proved to be very difficult and expensive, but instead of shutting down the project, the British and French governments continued funding it even though they knew the aircraft would not have any economic benefit. They argued that they had invested too much to give up.

experiment by hal arkes & catherine blumer
Experiment

To test the sunk cost fallacy, economists Hal Arkes and Catherine Blumer came up with an experiment using theater season tickets. The regular price for the season was $15, but some people were randomly given discounts of either $7 or $2. It turned out that the people who had paid the regular price attended more plays than those who received a discount. Interestingly, the only ones who behaved rationally were children under the age of 6.

three psychological reasons behind sunk cost
Three psychological reasons

Behavioral economists suggest that there are three psychological reasons for our irrationality.

1. Loss aversion: people prefer avoiding losses to acquiring equivalent gains — most avoid bets where they can win $50 because they could also lose $50.

2. The desire not to appear wasteful: this is why some finish their food even when they feel full or don’t think it’s particularly tasty.

3. To ensure we do things we fear we otherwise wouldn’t: We might buy expensive gym membership to make sure we actually go and work out.

what was your experience?
What was your experience

Assuming you are immune to the Concorde fallacy and you could completely ignore all investments you have ever made into your education or getting to where you are today: What would you be doing differently going forward? Can you identify any ‘sunk costs’ that are holding you back from making those changes?

Sources

Dig deeper!

Classroom activity

Here is a class activity that can help students understand the sunk cost fallacy:

  • Have the students imagine that they have placed a $5,000 non-refundable deposit on a venue for a wedding. Then ask them, if they were considering canceling the wedding, what the costs would be.
  • Watch our video on the topic.
  • After watching our video, explain to the students that, from an economic perspective, the cost of canceling the wedding is what we give up going forward. It does not include the cost of the venue rental, which has already been paid and cannot be recovered.
  • Divide the class into small groups. Give each group a scenario that involves a sunk cost (e.g. a group of friends has already paid for tickets to a big concert, but the particular artist they wanted to see cancels). Ask the groups to discuss and come up with a list of pros and cons for deciding what to do (e.g. whether to go to the concert or not).
  • Have the groups share their lists with the class. 
  • End with a discussion on whether the sunk cost fallacy is actually irrational or whether it can sometimes help us achieve goals that we might not have pursued otherwise (e.g. going to the gym because we paid for an annual membership).

Collaborators

  • Script: Jonas Koblin and Jonas Jaquet
  • Artist: Pascal Gaggelli
  • Voice: Matt Abbott
  • Coloring: Nalin
  • Editing: Peera Lertsukittipongsa
  • Sound Design: Miguel Ojeda
  • Production: Selina Bador
  • Proofreading: Susan 

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