Sunk Costs

Sunken Treasure

The Paradox of Sunk Costs

One of the most basic premises of economics is “Bygones are forever bygones”. We have touched upon the topic of sunk costs before here at Ambidextrous Economics, but further discussion is warranted.

What does it mean when a cost is sunk? When evaluating a decision, it is difficult to look past all the money that you’ve dumped into that project previously. The idea is simple enough: Don’t throw good money after bad. But why is it so difficult to get a grip on this?

On it’s first face, emotions don’t factor in for any particular dollar amount. But we use emotions all the time when evaluating decisions. The fact is there is a social cost to our decisions whether or not we can ascribe a particular amount. The fact of the matter is that its difficult to admit we’ve experienced loss of any type, and loss aversion is a powerful force.

To be loss averse is a normal part of being human. Being loss averse means we’re more affected by taking something away than we are by gaining that same thing. For instance, we may lose $10 in a hand of blackjack and it will affect us disproportionately more than if we won that $10 in a different hand. Something lingers. The regret of having something and then losing it affects us in a way that simple math cannot explain, and this is the conundrum of sunk costs.

When a pharmaceutical company is dumping millions of dollars in trials for experimental drugs, it is hard not to look back at that research and try to gain some of that money back. No one wants to admit that they made a mistake, much less one that cost the company millions of dollars. The alternative is having drugs on the market that simply aren’t safe enough for the Food and Drug Administration to allow in the market.

This raises some interesting questions. If the FDA isn’t willing to approve a drug because the costs exceed the benefits, what’s to stop another country from approving those drugs for sale? Nothing. In a case-by-case basis, a drug is then put on human trials through back channels. In this event, the costs switch from the potential that prescribing drugs that may have benefits to the real cost that some people may likely become sick or die from untested drugs. It’s not an easy decision, especially if you are the person who’s sick.

The important factor involved in the evaluation of sunk costs is that we sometimes forget to ascribe social costs to our equations. We may say that we’re saving $0.50 by using the same shower towel twice, but that means we don’t ascribe any value at all to the comfort provided by using a fresh towel each time. These hidden costs become more apparent through the decision-making analyses that go on apart from decisions where the dollar amounts are more salient. What is the value of a fresh towel each time you use a shower versus reusing the same towel two times? The fact that these numbers are not available to us does not mean that they do not exist. We may measure those costs as a function of affect, say, on a scale of 1 to 10, so the fact that they are difficult to see makes our decisions that much more difficult to evaluate in the midst of them.

Sunk costs affect all sorts of decisions. Through our language it is easy to see how ingrained the fallacy of sunk costs have become a part our everyday conventions.

• “Well, if we’ve gone this far…”

• “No sense turning back now…”

• “We didn’t do all this work for nothing…”

The difficult point to understand, but especially, to implement, is that at any decision making point, it is possible, even advisable in instances, to walk away. The problem is that our tools for evaluation are solely related to Return on Investment or Net Present Value. When adjusted for risk and time, we want benefits to exceed costs. Quite simply, it’s difficult for us to accept that a bad decision was made in the past when we’re so wired to do everything in our powers to see gains instead of losses. The hardest part is letting go of the fact that once a decision has been made, the passage of time has made it impossible to undo that decision.

AE - 10.23.2014

The Ambidextrous Economist will turn this car around. He can be reached at AmbidextrousEconomist@gmail.com.