Academic journal article Economic Inquiry

Do Sunk Costs Matter?

Academic journal article Economic Inquiry

Do Sunk Costs Matter?

Article excerpt

"Let Bygones Be Bygones."

--Khieu Samphan, former head of state of the Khmer Rouge government, asking Cambodians to forget the more than one million people who died under his government's rule.

I. INTRODUCTION

Sunk costs are costs that have already been incurred and cannot be recovered. Sunk costs do not change regardless of which action is presently chosen. Therefore, an individual should ignore sunk costs to make a rational choice. Introductory textbooks in economics present this as a basic principle of rational decision making (Frank and Bernanke 2006, 10; Mankiw 2004, 297).

Nonetheless, people are apparently often influenced by sunk costs in their decision making. Once individuals have made a large sunk investment, they have a tendency to invest more in an attempt to prevent their previous investment from being wasted. The greater the size of their sunk investment, the more they tend to invest further, even when the return on additional investment does not seem worthwhile. For example, some people remain in failing relationships because they "have already invested too much to leave." Others buy expensive gym memberships to commit themselves to exercising. Still others are swayed by arguments that a war must continue because lives will have been sacrificed in vain unless victory is achieved.

These types of behavior do not seem to accord with rational choice theory and are often classified as behavioral errors. People who commit them are said to be engaging in the "sunk cost fallacy." Students are repeatedly taught in economic classes that sunk costs are irrelevant to decision making so that they may ultimately learn to make better decisions, invoking the theory as a normative prescription. Conditioning on the level of sunk costs is also taken as evidence that people do not always make rational choices (Thaler 1991), suggesting that the explanatory power of rational choice theory is limited.

In this article, we argue that in a broad range of environments, reacting to sunk costs is actually rational. Agents may rationally react to sunk costs because of informational content, reputational concerns, or financial and time constraints.

A. Informational Content

Consider a project that may take an unknown expenditure to complete. The failure to complete the project with a given amount of investment is informative about the expected amount needed to complete it. Therefore, the expected additional investment required for fruition will be correlated with the sunk investment. Moreover, in a world of random returns, the realization of a return is informative about the expected value of continuing a project. A large loss, which leads to a rational inference of a high variance, will often lead to a higher option value because option values tend to rise with variance. Consequently, the informativeness of sunk investments is amplified by consideration of the option value.

B. Reputational Concerns

In team relationships, each participant's willingness to invest depends on the investments of others. In such circumstances, a commitment to finishing projects even when they appear ex post unprofitable is valuable because such a commitment induces more efficient ex ante investment. Thus, a reputation for "throwing good money after bad"--the classic sunk cost fallacy--can solve a coordination problem. In contrast to the desire for commitment, people might rationally want to conceal bad choices to appear more talented, which may lead them to make further investments, hoping to conceal their investments gone bad.

C. Financial and Time Constraints

Given financial constraints, larger past expenditures leave less ability to make future expenditures, ceteris paribus. Thus, financial constraints may lead companies or individuals to stick with projects that no longer appear to be the best choice. Moreover, given limited time to invest in projects, as the time remaining shrinks, individuals have less time over which to amortize their costs of experimenting with new projects and therefore may be rationally less likely to abandon current projects. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.