Sunk Costs

… a core concept in Economic Analysis and Atlas102

Concept description

The Economist (reference below) defines sunk costs as when what is done cannot be undone, and adds:

“Sunk costs are costs that have been incurred and cannot be reversed, for example, spending on advertising or researching a product idea. They can be a barrier to entry. If potential entrants would have to incur similar costs, which would not be recoverable if the entry failed, they may be scared off.”

Alex Tabarrok (reference below) defines sunk costs as a costs that once incurred can never be recovered.

Loss aversion and the sunk cost fallacy

Wikipedia (reference below) writes:

“Economists argue that sunk costs are not taken into account when making rational decisions. In the case of a baseball game ticket that has already been purchased, the ticket-buyer can choose between the following two end results if he realizes that he doesn’t like the game:

  1. Having paid the price of the ticket and having suffered watching a game that he does not want to see, or;
  2. Having paid the price of the ticket and having used the time to do something more fun.

“In either case, the ticket-buyer has paid the price of the ticket so that part of the decision no longer affects the future. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the game at all, regardless of the price, just as if he were to go to a free baseball game. The economist will suggest that, since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.

“Many people have strong misgivings about “wasting” resources (loss aversion). In the above example involving a non-refundable sporting event ticket, many people, for example, would feel obliged to go to the event 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.

“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 an event they won’t enjoy 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 they might otherwise choose to avoid. Alternatively, they 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.”

Steven Nickolas, writing in Investopedia (reference below), addresses the question: Why should sunk costs be ignored in future decision making? He says:

“Since decision-making only affects the future course of business, sunk costs should be irrelevant in the decision-making process. Instead, a decision maker should base her strategy on how to proceed with business or investment activities on future costs.

“For example, suppose a business executive of a finance consulting company is hired to build a financial analytics application and will receive $10 million at the end of the project. The business executive determines it will cost $7 million in total to finish the project and take one year. The company will profit $3 million for completing this project.

“However, in the ninth month of operation, her team runs into problems with the main framework of the application. The firm already spent $5.25 million on this project, and the business executive must decide whether to continue with the project or cancel it. She estimates that this major setback will cost an extra $1 million. However, the company can still profit $2 million from the project.

“Whether the business executive decides to continue with the project or cancel it, the costs spent for the nine months of operation cannot be retrieved. This should be irrelevant to her decision because only future costs and potential revenues should be considered. If she cancels the project, the company would incur a $5.25 million loss and have revenues of $0. If she continues with the project, the future revenue for the company is $10 million, and future costs are only $2.75 million.

“She decides to continue with the project because it is a 3.64 return on investment, ignoring sunk costs. The consulting company delivers its application to the hirer and receives revenues of $10 million and has a profit of $2 million.”

Atlas topic, subject, and course

Producer Theory and Competition (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Sources

The Economist, Sunk costs, Economics A-Z, at http://www.economist.com/economics-a-to-z/s#node-21529345, accessed 6 May 2016.

Alex Tabarrok, minute 10:13 in video, Maximizing Profit and the Average Cost Curve, Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-average-cost, accessed 6 May 2016.

Wikipedia, at Sunk cost, at https://en.wikipedia.org/wiki/Sunk_cost#Loss_aversion_and_the_sunk_cost_fallacy, accessed 1 June 2017.

Steven Nickolas, Why should sunk costs be ignored in future decision making?, Investopedia, at http://www.investopedia.com/ask/answers/042115/why-should-sunk-costs-be-ignored-future-decision-making.asp, accessed 6 May 2016.

Page created by: Ian Clark, last modified 1 June 2016.

Image: Kissmetrics Blog, at https://blog.kissmetrics.com/growth-plateau/, accessed 1 June 2017.