Sunk Costs - Loss Aversion and The Sunk Cost Fallacy

Loss Aversion and The Sunk Cost Fallacy

Many people have strong misgivings about "wasting" resources (loss aversion). In the above example involving a non-refundable movie ticket, many people, for example, would feel obliged to go to the movie despite not really wanting to, because doing otherwise would be wasting the ticket price; they feel they've passed the point of no return. This is sometimes referred to as 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 decision being made. Colloquially, this is known as "throwing good money after bad".

This line of thinking, in turn, may reflect a non-standard measure of utility, which is ultimately subjective and unique to the consumer. A ticket-buyer who purchases a ticket to a bad movie in advance makes a semi-public commitment to watching it. To leave early is to make this lapse of judgment manifest to strangers, an appearance he might otherwise choose to avoid. Alternatively, he may take pride in having recognized the opportunity cost of the alternative use of time.

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. A second example is R&D costs. Once spent, such costs are sunk and should have no effect on future pricing decisions. So a pharmaceutical company’s attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars. However, R&D costs, and the ability to recoup those costs, are a factor in deciding whether to spend the money on R&D.

The sunk cost fallacy is in game theory sometimes known as the "Concorde Fallacy", referring to the fact that the British and French governments continued to fund the joint development of Concorde even after it became apparent that there was no longer an economic case for the aircraft. The project was regarded privately by the British government as a "commercial disaster" which should never have been started, and was almost cancelled, but political and legal issues had ultimately made it impossible for either government to pull out.