In economics, a sunk cost is any cost that has already been paid and cannot be recovered.
The sunk cost fallacy is a mistake in reasoning in which the sunk costs of an activity – instead of the future costs and benefits – are considered when deciding whether to continue the activity.
The sunk cost fallacy makes it more likely that a person or an organization continues with an activity in which they have already invested money, time, or effort, even if they would not start the activity had they not already invested in it. The greater the size of the sunk investment, the more people tend to invest further, even when the return on added investment appears not to be worthwhile.
This trap is sometimes described as “throwing good money after bad,” because the resources and efforts are already lost, no matter what you do now.
Let’s do an example. You have ve bought a ticket to the ballet. At some point you are informed that your favourite ballerina – the main reason for having bought the ticket – is not dancing owing to health issues. You should not decide to go on the basis that you have spent money on the ticket; instead you should decide based on the current circumstances: ‘I’ve just learned that my favourite ballerina is not dancing, therefore I won’t go’, rather than ‘I have spent all this money and I don’t want to waste it…’.
According to researchers Daniel Kahneman and Amos Tversky, the main reason people fall prey to the sunk cost fallacy is the loss aversion: people tend to have a much stronger preference for avoiding losses than for acquiring gains. Continuing an activity based on sunk costs enables us to avoid (at least for the short run) what social psychologist Dan Ariely calls “the pain of paying.”
There are also two other factors that characterize the sunk-cost heuristic:
- over-optimistic estimate of probability of success: in order to avoid the regret avoidance and possibly to reduce cognitive dissonance having made a decision. In fact, the loss aversion fallacy teaches us that people attribute excessive weight to events with low probabilities (success in this case) and insufficient weight to events with high probability (failure in this case).
- personal responsibility: when you are personally accountable, it is difficult to admit you were wrong: justifying our past behavior, maintaining the appearance that we did not make a mistake, and avoiding the regret that we would experience by stopping the activity in which the investment was made.
Sunk costs are “irrelevant data” from an economic viewpoint because they are independent of any possible future event: continuing an activity only because of prior investment is thus seen as irrational behavior unlikely to result in the best outcome.
Author David McRaney describes the sunk cost fallacy as continuing “a wasteful loop of behavior because of your fear of loss.” Waste of resources matters in business, public affairs and economics.
The Concorde Experience is a paradigmatic example of sunk-cost heuristic.
Why would two countries waste huge sums of money over four decades to develop a airplane that no one would buy except their own national airlines who were heavily subsidized to do so?
Consider the case of the Concorde, the first supersonic (SST) commercial airliner. The Concorde was built in a 42-year program by a consortium of British and French companies backed by their governments.
Concorde development began in 1962 based on a treaty between the two countries. The plane began commercial service in 1976 and flew for 27 years. The costs to develop the Concorde were £1.134 billion, which was funded by the UK and French governments. The cost to build the small number of Concordes produced for commercial service, 16, was £654 million, of which only £278 million was recovered through sales. This debt was also funded by the two governments.
Consultant Peter Saxton, a former RAF pilot and British Airways Captain, chief pilot and senior manager, says the Concorde was “a project which cost the British and French tax-payers a staggering amount for development and construction, was not well managed if massive cost overruns are anything to go by, never made anything close to a financial return for its investors (us), and led the British aircraft industry into a cul-de-sac.” He calls it a “a stupendous example of a project that was kept alive for a whole raft of reasons, none of which seems to have included the serious intention of making a commercial return for investors. Those reasons…included maintaining technological expertise, providing employment, securing Britain’s entry into the European Common Market, and patriotism or prestige.” Saxton surmises that the governments kept “throwing more good money after bad” because they “seemed prepared to pay the prestige premium no matter how high it rose.”
It was this “escalation of commitment” that gave the sunk cost fallacy a new name: the Concorde effect.
In economics, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered: it refers to money.
But we should look at the sunk cost bias in a broader view, intending for “costs” all the possible invested resources (money, time, efforts, sacrifices, penalties, ecc.). Therefore, individuals commit the sunk cost fallacy when they continue a behavior or endeavor just on the base of the previously invested resources.
For example, individuals sometimes order too much food and then over-eat ‘just to get their money’s worth’.
Similarly, a person may have a $50 ticket to a concert and then drive for hours through a blizzard, just because she feels that she has to attend due to having made the initial investment.
The same fallacy happens with religions. When you have invested a significant portion of your lifetime and energy in a religion, you feel that, by saying goodbye to it and moving on with a more rational life, you shall effectively lose your investment and never recover from the loss. The fear of loss is a powerful force of stagnation, both in human behaviour and the general economy. It paralyses people who wish to break free of a particular set of circumstances but feel apprehensive of the associated losses.