Decision Making: Sunk Cost Fallacy

Posted by

The sunk cost fallacy makes us stupid. Don’t let it trick you.

What is the sunk cost fallacy?

In economics, the sunk cost fallacy is any cost that has been already incurred and cannot be recovered. For example, businesses that spend money on research and development. You can’t “refund” research and development and undo the research. Behavioral economics teaches us that we should then make sure to NOT factor these costs into future decision making.

A traditional example is buying tickets to an event, like a concert or maybe to prom. Let’s say the day of the event, you get incredibly sick, and you’re just completely lethargic. The sunk cost fallacy would trick you into still going to the event because you’ve already paid for the ticket. But here’s the thing, the ticket price is a sunk cost, and shouldn’t be factored into future decisions. Here you have two results, both containing the price of the ticket having already been paid (sunk cost).

  1. You are short -$20 the cost of the ticket, and you choose to go to the event and have a terrible time;
  2. You are short -$20 the cost of the ticket, and you choose to stay in and watch Netflix with your family and rest up with some good chicken noodle soup and have a pretty good night anyways

Either way, you will have paid the price of the ticket, because it’s a sunk cost and non-refundable, so you shouldn’t factor the price into your decision making. Really, the options are this:

  1. Go to event and have a terrible time
  2. Stay home and watch Netflix and relax and recover

Pretty simple in making the right decision here.

SUNK COST FALLACY MAKES YOU INCUR STUPID FUTURE COSTS.

Let bygones be bygones.

The best example I can think of in better understanding the logic behind sunk costs is in poker.

Let’s say throughout the game, you continually bet some amount of money through the deal, the flop (3 cards are showed), and the turn (fourth card). By the river (final card), you have a sizeable amount of money already in the pot, and it is just you against one other person. Here’s the thing: in this scenario, somehow both you and your opponent KNOW for certain that you have absolutely no chance of winning, regardless of what the river card is. Your opponent bets $1. Do you call?

Sunk cost fallacy would trick you into giving up one more dollar because you already have “so much in the pot.” Your past investment makes you want to carry through. But as a strategic poker player who might have studied some behavioral economics and decision making, you’d know that even though it’s only $1, you shouldn’t make the extra bet because you know for certain you’d lose. Regardless of the bet amount. It could be $1000, or it could be 1 penny.

A famous example of sunk cost fallacy incurring stupid future costs is the Concorde fallacy. Wikipedia notes:

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.

Here are some scenarios of sunk cost fallacies

1) I’ve already read half the book, and even though I hate it, I might as well finish it

You can’t get your invested time back into reading the first half of the book. Time is always a sunk cost (you can’t refund time). But just because you already read half the book doesn’t justify continuing to finish the book when you hate it. This goes for movies and TV series too. The issue is, if the first 50% of it is bad, how likely is the last half going to turn out amazing? Very rarely.

2) I might as well keep working at this job because I’ve spent so much time and energy climbing the corporate ladder

Your brain makes you dumb. The time you’ve spent and the resources you’ve used up at this job is a sunk cost. If you hate the job and feel like your future outlook will be miserable, why continue? You might think that since you’re already climbed up so far, that you’ll enjoy yourself more once you get to the top. Big mistake. Again, how likely will the last half of the ladder be amazing, if the first half was terrible?

A good way to fight against the sunk cost fallacy is to ask yourself: given the knowledge I have now, would I have started this in the first place?

3) I should just keep taking this class even though I think I’ll learn nothing because I already paid the tuition

Let’s say you’re super excited to take this computer science class because you think you’ll get to learn some good coding skills. Turns out your professor hates his job (probably should have taken a behavioral economics class and quit 10 years ago. But he was chasing tenure). The course content is incredibly mundane, and you feel like you could probably teach the course rather than be a student. But you already paid the tuition (sunk cost), so you might as well finish the course, right?

Well here’s the thing. Just because you’ve paid the tuition (can’t get back), doesn’t justify you to continue using time and resources to taking the course. If you know for certain the end result is a loss, you should not hesitate to bail, even if the bet is just $1 more. That time is big opportunity cost!

At the end of the day, the sunk cost fallacy is caused by pride, loss aversion, and irrational commitment to past decisions.

So how do we combat sunk cost fallacy?

Well, it’s easy enough to say that once you notice that something is a sunk cost, you need to make sure that it doesn’t factor into your future decision making. But that’s a bit hard.

Really, the key point here is to understand that it’s okay to quit something mid-way. 

Put your pride aside. Even if you’ve put in a lot of commitment, and you think that you’ll have “wasted all that time” if you don’t continue climbing the corporate ladder, you need to realize that it’d be an irrational decision. Instead, consider the sunk costs as a payment to realize that this career path is not the right path.

It’s okay to walk away from failed projects. Use that extra time, that opportunity cost, to invest in something else.

Instead of finishing the last hour of a terrible movie, used that extra hour to do something else that’s fun.

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s