Category Archives: sunk costs

The fallacy of sunk costs (or why you can’t buy our SUV)



Dammit
, we thought sitting in traffic last night, we’re upside down on our SUV. Not crashed upside down; finance-lingo upside down, meaning our gas-guzzler has depreciated so much that if we sold it tomorrow, we’d still owe $3,000 on the loan.

Now the reality is if we swapped to a new hybrid, we’d save about $3,500 a year on gas (we drive a lot) — netting a profit of $500 by next summer. But we won’t switch. Because we don’t want to lose $3,000 or admit it. We’re stuck in the logic trap of a sunk cost.

Sunk costs are past expenses or decisions that can never be recovered, and economists say it is a trap to consider them when making a decision today. But people do this, because we hate to feel regret. The classic example is an expensive theater ticket. Imagine you’re sitting home Friday night, and have a choice — you could go out to the theater, or stay home and read a novel. That night, you’re tired, so you really prefer to stay home. But you paid $200 for a theater ticket, and it is nonrefundable, so you feel compelled to go to the theater anyway.

This is a logic trap because your past cost is “sunk” — and your decision tonight will never recover the money, either way. A rational choice would be to stay home, where you derive more pleasure. Just like our rational choice would be to sell our SUV.

Sunk costs create problems when managers follow a chain of decisions because of past decisions. Some (ahem) note the Vietnam War is a classic example of chasing sunk costs; the thought was we had spent too much, and lost too many lives, to “stop the war now.” The decision of investors to continue to throw money at the Concorde jet for years was another example of chasing sunk costs. Psychologically, people are reluctant to admit they failed in the past, and they seek to avoid regret in the future (which is one reason why you don’t cheat on your spouse).

Marketers make mistakes chasing sunk costs, too. Investments in past creative, in brand identities that fail, or in media campaign components that aren’t working tend to create the inertia of “we can’t change it now.” Game theorists point out that in many campaigns, sunk costs create end failure because at any single point in the decision process — do we start? continue? continue again? — the instant decision seems logical, to move ahead for a chance at a near-term gain … while in the end the result may be a negative return.

You can’t change yesterday. But yesterday influences us strongly.

On the positive side, Thomas Kelly of Notre Dame argues that honoring sunk costs may have advantages if the psychology of thrift and loss avoidance has greater overall impact in decision making. Maybe he’ll buy our SUV.

Photo: Hamed Saber