• EconAfterHours

Examining the sunk cost

Updated: Mar 11, 2020

By Namrata Caleb

The concept of sunk cost is one which is introduced to economics students pretty early on.  Sunk costs are costs that have already been incurred and cannot be recovered. This idea is quite well captured in the phrases “Let bygones be bygones” or “Why cry over spilt milk”.  Sunk costs do not change regardless of which course of action is chosen. An individual should ignore sunk costs to make a rational choice and instead continue investing in a particular activity, only if the future returns from it are sufficiently high. We behave irrationally, according to standard economic theory, when we sit through Tanu weds Manu Returns, simply because we paid a decent amount for the ticket or when we force down our throats a particularly unsavoury dish simply because it was rather expensive. Similarly, evidence shows that firms sometimes invest more in an unproductive project when they’ve made a significantly large sunk investment.

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Let’s look at how honouring sunk costs is not necessarily non-optimizing or irrational behaviour. When taking certain decisions, we consciously decide to take into account certain sunk costs to bind ourselves into doing something we deem undesirable yet beneficial.  For example, going to the gym or just exercising regularly in general, is a painfully difficult resolution to keep. It’s a huge investment of time, effort not to mention the pain of stretched, sore muscles. And yet, it’s common knowledge that going to the gym is highly beneficial to our bodies. It makes us fitter, faster and more flexible. So how do I ensure that end up in the gym every morning? Easy, I just pay my yearly gym subscription in the beginning of every year! Because I know that I’ve already paid a massive amount, which is absolutely non-refundable, it gives me an incentive and that much needed push to get me to the gym every morning. Reminding myself of a cost that is certainly sunk, but a cost that helps me stay healthy for the foreseeable future. There are a number of examples where individuals have benefited by not ignoring the sunk cost. In general, a number of success stories illustrate how individuals persevered despite the fact that short-term odds were not in their favour simply because they had invested too much to give up now. Individuals, like you and me, despite possessing an’ economic sense’, we might exploit our own psychological reactions to use sunken expenditures to our advantage. We spend thousands of rupees on gym equipment and memberships to compel ourselves to go to the gym even if we don’t want to. Consider a relationship. People often say that they aren’t willing to part from their spouse, simply because “they’ve invested far too much” into a relationship, and thus they are willing to make the effort to make the relationship work. Also, refusing to abandon projects with large sunk costs creates a reputation for commitment [1]. In a team effort, if one person pulls out of a project, others suffer as well. The willingness to continue investing in an unfavourable situation might show commitment, inducing investment by others as well which contributes to the success of the project in the long-run. In a marriage, an important aspect of the incentive to “stick together” is the belief that the other person will stay as well. If sudden troubles cause a spouse to lose faith in her long-term relationship, he or she will invest less in the relationship now, and thus potentially ruin her relationship. Decisions taken now, have tremendous impact on the success of human relations and thus have self-fulfilling qualities. Moreover, the success or failure of projects also creates a reputation for ability [2]. A politician’s ability to distinguish between viable and un-viable projects depends on his or her ability. In addition, politicians are in a position to heavily discount their future if they believe that their re-election is unlikely. If they maintain their reputation, they will remain in power and if they don’t they will be thrown out. If they receive information, close to the re-election date, that a particular project is bad, they will be unlikely to reveal it if they wish to stay in power. This is true of politicians who are corrupt and not inclined towards working for the public. If the scam is exposed, and the massive social and economic cost of the project is thrown open to the public, it is not in the best interest of the electorate to ignore this cost as a sunk cost. In fact, a failure today is indicative of a propensity to fail in the future.  Thus, the politician is unlikely to be re-elected. Honouring sunk costs are beneficial on some occasions particularly due to the fact that they are part and parcel of common human psychological behaviour. We consciously exploit our reactions to compel ourselves to do certain undesirable, yet immensely beneficial activities. We preserve and invest in a number of our social relationships, because we believe that this will show commitment. We recognize that failures and their imposed costs cannot be thought of as “sunk” because they are indicative of an individual’s abilities. And thus, in a number of circumstances, honouring a sunk cost may not be completely irrational economic behaviour. [1] Do Sunk Costs Matter? R. Preston McAfee, Hugo M. Mialon, and Sue H. Mialon, April 2007http://vita.mcafee.cc/PDF/SunkCostFolly.pdf Accessed on 30th June 2015 [2] Do Sunk Costs Matter? R. Preston McAfee, Hugo M. Mialon, and Sue H. Mialon, April 2007http://vita.mcafee.cc/PDF/SunkCostFolly.pdf Accessed on 30th June 2015

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