What Is Sunk Cost and the Sunk Cost Fallacy?

A comprehensive guide to sunk costs, their implications in decision-making, and avoiding the sunk cost fallacy. Learn about different types of sunk costs, how they affect economic choices, and practical examples.

A sunk cost is an expenditure that has already been incurred and cannot be recovered. These costs are considered irretrievable and should be excluded from future decision-making processes. Sunk costs can often bias individuals or businesses into making irrational choices, primarily due to the mistaken belief that past investments justify further spending.

Types of Sunk Costs

Capital Investments

Capital investments such as machinery, equipment, or infrastructure that have already been purchased and activated are typical examples of sunk costs. Regardless of future business decisions, the initial expenditure remains unchanged and should not influence new choices.

Marketing and Advertising Expenses

Funds spent on marketing and advertising campaigns are also considered sunk costs once the campaigns have launched. These expenses should not sway future marketing strategies or budget allocations.

The Sunk Cost Fallacy

The sunk cost fallacy is a common cognitive bias where individuals or organizations continue an endeavor solely based on the time, effort, or money already spent, regardless of future benefits or losses. This fallacy often leads to poor decision-making and continued investment in failing projects.

Historical Context and Examples

Historical Examples

One prominent historical example is the Concorde Supersonic Jet project. Despite mounting evidence of its financial infeasibility, the British and French governments continued to fund the project due to the significant investments already made—a classic case of the sunk cost fallacy.

Practical Examples

Consider a business that has spent $1 million developing a new product. If market analysis later reveals a low chance of success, the $1 million should be considered a sunk cost and not factor into the decision of whether to continue or abandon the project.

Applicability and Decision-Making

In Economics

Economists emphasize the need to ignore sunk costs in rational decision-making. Future choices should be based on prospective costs and benefits, uninfluenced by past expenditures that cannot be recovered.

Comparisons and Related Terms

Opportunity Cost

While sunk costs are about irretrievable past expenditures, opportunity cost refers to the benefits missed out on when choosing one alternative over another. Opportunity costs are forward-looking and crucial in decision-making processes.

Fixed Costs vs. Sunk Costs

Both fixed costs and sunk costs are expenditures that a company incurs regardless of production levels. However, fixed costs can be relevant for short-term decision-making, while sunk costs should never influence decisions.

FAQs

Why Should Sunk Costs Be Ignored?

Sunk costs should be ignored because they do not change regardless of the outcome of a decision. Focusing on potential future benefits and costs ensures more rational and economically sound decisions.

How Can One Avoid the Sunk Cost Fallacy?

One can avoid the sunk cost fallacy by acknowledging that past expenses cannot be recovered and should not affect current decision-making. Regularly reassessing decisions based on current and future data rather than past investments can also help.

References

1. Thaler, R. H. (1980). Toward a Positive Theory of Consumer Choice. Journal of Economic Behavior & Organization, 1(1), 39-60.
2. Arkes, H. R., & Blumer, C. (1985). The Psychology of Sunk Cost. Organizational Behavior and Human Decision Processes, 35(1), 124-140.

Summary

Understanding sunk costs and the sunk cost fallacy is crucial for making rational economic and business decisions. By recognizing that past expenditures should not dictate future actions, individuals and organizations can avoid the pitfalls of biased decision-making and allocate resources more effectively.