What are ‘sunk costs’?
‘Sunk cost’ is a term commonly used in economics. It refers to a cost that you or a firm might incur which is irretrievable – you can’t get it back.
Suppose you own a large cheese company which has a cheese factory. You want to build an extension to your factory after a bumper year of exotic cheese sales (sorry, it’s lunchtime). If you bought some steel girders for £100,000 to lay some sort of framework down, the money you spent on that is now sunk. The frame is in the ground and has been constructed, and there’s not much you can do about that now.
Classic economic theory says that individuals and firms behave rationally. Therefore, because sunk costs cannot be retrieved, you should ignore them completely when making another decision. Theoretically, you should only think about future costs and benefits.
Going back to your cheese factory, suppose the local council decided that your extension wasn’t legal and stopped the construction from going any further. You have 2 options:
1. Do nothing and tear down the frame
2. Appeal, which costs you £50,000 in legal bills, but only has 1% chance of success
The rational choice would be number 1 (assuming your valuation of a successful appeal is less than £50,000). You are going to lose nothing by doing nothing, whereas appealing would cost you £50,000 with very little chance of any gain.
Note that in this decision, we have ignored the £100,000 we already spent on steel, because it was a sunk cost. But would you actually do this in reality? Wouldn’t the fact that you had already committed £100,000 to the project make you want to appeal, so that there may be a chance (however small) that your money wasn’t thrown away?
Why sunk costs aren’t sunk in practice
There are two main issues that seem to contribute to people not treating sunk costs in a rational manner. The first is loss aversion – the idea that people really don’t like losing things. For example would you choose option A or option B when faced with the following two gambles?
A: 50% chance of winning £40, 50% chance of losing £20
B: 50% chance of winning £20, 50% chance of getting nothing
Both have the same expected value of £10, and so if you were rational, you would be indifferent between either of the two options. But I’d choose option B, and evidence suggests that most people would choose an option like B because the potential loss of £20 is actually psychologically scarier than it is mathematically.
The second point of irrationality is that people don’t forget what happened in the past. If you lost some money in the past, it stings, and you are likely to remember that and use that experience for future decisions. Of course, learning from past successes and failures is a trait that has allowed the human race to survive and develop over thousands of years.
However, there are certain things that happen that we cannot do anything about. These instances tend to cloud our judgement when making future decisions and result in us making unwise (and sometimes amusing!) choices.
Loss + Past = Sunk
Sunk costs are ‘losses’ that happened in the past. We should forget about them – but because we use past information to make future decisions and because losses stick out as being particularly painful – we don’t.
My favourite real-life example of a sunk cost not being ignored is based on an observation by economist Richard Thaler (and is particularly applicable to the fairer sex!):
You go shopping and find some wonderful shoes (maybe like the ones in the picture at the top of the page). You try them on in the shop briefly and they seem fine. But then you take them home and try to wear them the following day. They turn out to be painfully uncomfortable to wear for more than 15 minutes, giving you blisters and bruises. Wearing them is unhealthy for your feet. You have absolutely nothing to gain by keeping the shoes, so do you throw them out?
Experience suggests that you won’t!
You try to wear them in on the following day, and the next. After a few days/weeks, you realise that it’s no good and so they sit in the back of your wardrobe for a couple of months until the money you spent on them has been psychologically exhausted. Then you finally throw them away!
The amount of time you keep them corresponds to the amount you spend on the shoes. It seems that the severity of the sunk cost you incurred has a direct psychological effect on your decision. It’s almost as if the more expensive the shoes are, the longer you will be blind to their uselessness!
For example, if you spend £30 on them, then you might decide to throw them out after a month or two. But if you spent £300 on them, I’d bet you would make a bigger effort to ‘make them fit’ and that they’d eventually sit around for a lot longer (maybe years!) until you decide they’re finally a waste of space!
This is a funny and fairly harmless example of how sunk costs aren’t actually treated as being sunk in reality. However, in many situations this kind of behaviour can lead to catastrophically bad decisions. Governments are all too susceptible. In many cases, they may carry on with projects, spending billions, even when it seems like the project may be canned or of no use anymore (UK Identity Cards, anyone?). I think that it’s important for us to know as many shortcomings of our decision-making processes as possible, so that we can avoid wasting time, energy and resources in future.