Sunk cost Opportunity Cost, Rational Decision-Making & Behavioral Biases

It can’t be recovered and therefore shouldn’t be a factor in decisions moving forward because no matter what, it can’t be recouped. Businesses and organizations often have difficulty abandoning strategies because of the time spent developing them, even if they aren’t the right choice for the company. Overcoming the sunk cost dilemma involves recognizing sunk costs, reframing your perspective, evaluating the current situation, and considering opportunity cost. You must usually be deliberate when considering sunk costs and be mindful of how they may (or more importantly not) have implications on future decisions. Irrational decision-making in the sunk cost dilemma involves making choices based on past investments rather than evaluating the current situation and potential future gains. This often leads to inefficient resource allocation, as capital is invested based on what can no longer be changed instead of what has the most future benefit.

The sunk cost dilemma is not resolved as long as the project is neither completed nor stopped. A sunk cost, sometimes called a retrospective cost, refers to an investment already incurred that can’t be recovered. Examples of sunk costs in business include marketing, research, new software installation or equipment, salaries and benefits, or facilities expenses. By comparison, opportunity costs are lost returns from resources that were invested elsewhere. However, the rational decision was to confront the sunk cost dilemma and evaluate the project objectively.

A sunk cost is a cost that has already occurred and cannot be recovered by any means. Sunk costs are independent of any event and should not be considered when making investment or project decisions. Only relevant costs (costs that relate to a specific decision and will change depending on that decision) should be considered when making such decisions. The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Imagine a non-financial example of a college student trying to determine their major.

It’s founded in the common-sense principle that just because you’ve spent money on something up to a point, there’s no reason to keep spending money on it if the chances of recovering your investment are doubtful. Economists have a term for spending on things you can’t recoup your money from; they’re called “sunk costs.” Is there still potential for a positive outcome if you continue investing your resources and energy? These are the factors that should influence your decision rather than any previously sunk costs. A sunk cost is an expense that cannot be recovered by additional spending or investment. Businesses should be careful to exclude sunk costs from future decisions because they will remain the same regardless of the outcome of those decisions.

How Sunk Cost Fallacy Shows Up in Our Lives

Yes, the sunk cost dilemma is prevalent in business contexts where investments have been made in projects, products, or ventures that are not performing as expected. Companies must often pivot projects, make capital allocation decisions, and track your charitable donations to save you money at tax time make tough decisions on when to forgo continuing a project. An example of a sunk cost would be spending $5 million on building a factory that is projected to cost $10 million. The $5 million already spent—the sunk cost—should not be taken into account when deciding whether the factory should be completed.

A ticket buyer who purchases a ticket in advance to an event they eventually turn out not to enjoy 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. As well, the person may not want to leave the event because they have already paid, so they may feel that leaving would waste their expenditure. Alternatively, they may take a sense of pride in having recognised the opportunity cost of the alternative use of time. There’s four common explanations as to why the sunk cost fallacy exists. Here are the psychological reasons that explain why some decision-making processes fail.

To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand. Because sunk costs do not change, they should not be considered. Rego, Arantes, and Magalhães point out that the sunk cost effect exists in committed relationships. The sunk cost dilemma, when attempted to be resolved, requires an evaluation of whether further investment would just be throwing good money after bad.

How to Avoid Sunk Cost Fallacy in Decision-Making

It has since become an iconic symbol of Australia and a thriving cultural and economic hub. Some may say decision-makers succumbed to the sunk cost dilemma, though one could argue continue with the project was ultimately the correct move. The store receipt shows the refund period or the number of days you have to change your mind and make a return and get your money back. This period is known as the retrievable cost because you still have time the retrieve your money from the store. If you’ve passed that period—some may give you as many as 90 days to get a refund—then you may not be able to get a refund, resulting in a sunk cost. When a business or investor spends more money trying to reverse past losses, they risk succumbing to the sunk cost fallacy.

Sunk Cost Dilemma

Architect Jørn Utzon’s innovative design, while iconic today, posed significant technical difficulties and was much more complex to develop than initially anticipated. Understanding the underlying psychology of the sunk cost mindset can shed light on why it’s so difficult to let go. Taken together, these results suggest that the sunk cost effect may reflect non-standard measures of utility, which is ultimately subjective and unique to the individual. Some may call you a fair weather fan, but the cost became sunk the instant you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive, but if leaving makes you happier, do it!

A student may declare as an accounting major, only to realize after two accounting classes that this is not the career path for them. The sunk cost fallacy would make the student believe committing to the accounting major is worth it because resources have already been spent on the decision. In reality, the student should only evaluate the courses remaining and courses required for a different major. Sunk costs also cover certain expenses that are committed but yet to paid. Imagine a company that has entered into a contract to buy 1,000 pounds of raw materials for the next six months. Fixed costs are expenses that do not change with a given change in activity level.

The purely rational economic person would consider only the variable costs, but most people irrationally factor the sunk costs into our decisions. The best way to illustrate this concept is with an example that has played out many times over the past several years. You’re a homebuilder during the bubble and you’ve started work on 20 spec homes in a small development. You’ve cleared the land, prepped the home sites and brought in power, water and sewer.

As the costs escalated and the challenges mounted, the government and project stakeholders were faced with a dilemma. They had already invested a considerable amount of money and effort into the project, and abandoning it would mean admitting failure and wasting the funds that had been spent. This emotional attachment to the sunk costs could have led to the decision to continue investing more in the project.

Alternatively, when people have invested their own money, time, or effort into something, they may develop a sense of ownership and attachment, making it harder to let go. This also relates to the difficulty of letting something go in which time, not only dollars, have been invested.. Let’s take a look at how the Sunk Cost Dilemma works and how it relates to rational thinking. The dilemma comes into effect when you consider the money you’ve already spent, as well as money that will be spent in the future. It’s not financially prudent to walk away from something because of the money you’ve put into the decision, but you also can’t walk away because doing so will cost you more money as well. Ahead, we’re discussing some of the dangers of falling into this cognitive bias and outlining some common scenarios where sunk cost fallacy can show up in your life.

1. There’s an old saying that you shouldn’t throw good money after bad.
2. In general, businesses pay more attention to fixed and sunk costs than people, as both types of costs impact profits.
3. Opportunity cost is the concept of what you give up by choosing one option over another.
4. The store receipt shows the refund period or the number of days you have to change your mind and make a return and get your money back.
5. The framing effect which underlies the sunk cost effect builds upon the concept of extensionality where the outcome is the same regardless of how the information is framed.

The sunk cost fallacy is the improper mindset a what is a special journal definition meaning example company or individual may have when working through a decision. This fallacy is based on the premise that committing to the current plan is justified because resources have already been committed. This mistake may result in improper long-term strategic planning decisions based on short-term committed costs. Maybe you went to law school, passed the bar, started working, and then realized you hate being a lawyer. You invested so much time, energy, and money in that degree, so it can’t be worth starting over again with a new career, right?