1. In order to understand the sunk cost fallacy, let us take an example of a couple of friends that go to the local basketball match. A common example of a sunk cost fallacy involves buying a car. Required fields are marked. A restaurateur is considering expanding his restaurant into a chain. Sunk cost fallacy. A plane ticket that can’t be refunded is a sunk cost. However, if CD’s are no longer selling, it would be more rational to write off these sunk costs, rather than wasting more money on developing a product which will never make a profit. If the future looks brighter without the project at hand, then cut your losses and let it go. Saving money in the event of a sunk cost doesn't mean getting any of that money back, but it can mean avoiding losing additional money. The first step is to define your vision and make your decisions based solely on that. RSVP to the charity fundraiser three months ahead of time. Now you've wound up in the sunk cost dilemma. In business, a sunk cost fallacy can cost a business greater financial losses. In business and economics, a “sunk cost” refers to any cost that has been paid and cannot be recovered. In part, this is why the successful drugs are so expensive, but provide a huge sunk cost to the industry. But you still feel obligated to go through with eating the entire pizza since you spent $15 on it. But the 6th cake gives negative utility – 30 utils. Millions were spent before it became clear that the project was economically unviable. RSVPing doesn’t cost a thing. If you eat the 6th and 7th cake because you have bought it, you are making yourself worse off. Costs were high, and revenue limited. For example, suppose a firm invested $1bn in research for developing a more efficient CD player, it may feel that because it has invested $1bn, it should continue with more research until it can bring it to the market and get something back for this $1bn. The truth is that no one is perfect. In behavioural economics, prospect theory states that people tend to become risk-takers when faced with a loss. Develop creative tension. However, if you ignore these sunk costs, you are free to make a choice about which career you prefer to do. Should that employee leave after a few weeks, the cost to train them up can effectively be classed as a sunk cost. Another way to look at this is by saying that “investments justify further expenditures.” Once we have put money … 1. © 2020 TheStreet, Inc. All rights reserved. We have a tendency to bin outcomes into separate accounts. The money that was spent cannot be recovered, so it shouldn’t be a factor in the business’s future decisions if two years later it is best to spend more money on an entirely new system. A fallacy is defined as a commonly mistaken belief. Give your dilemma careful consideration, especially since many of these dilemmas involve far more money than just what a few paint cans' worth. The sunk cost fallacy (also known as the “Concorde fallacy”) is the idea that we are likely to go through commitments or events if we have already “paid” for them. >> Click to Grab the FREE Book: The Morning Routine for Peak Performance<<. Because these costs cannot be retrieved, they should not factor at all into future financial decisions. You are welcome to ask any questions on Economics. Supermarkets take daily deliveries of fresh produce and other goods. The ticket cost them $20 each, with the match lasting roughly 3 hours. Letting go of anything that has taken up so much of your money and time is a difficult thing to do, especially if you have developed a large emotional attachment. This makes it very difficult for any new firm to enter the market and produce their own cola. Suppose you buy seven cakes for £5.00 costing £35.00 – how much should you eat? Let’s say you go to see a new movie at the theater. Learn to be able to acknowledge a loss and move on. (Shortform suggestions: treat your time as costing $X per hour. Commentdocument.getElementById("comment").setAttribute( "id", "a2e6286321a298df78cdd88f7615423b" );document.getElementById("ea98f09dcc").setAttribute( "id", "comment" ); Cracking Economics But if you want to use the Sunk Cost fallacy to your advantage, sign up for a challenge, a class, or an event before you go. If we take the pharma industry as an example – it spends billions each year on research and developing new drugs. Reserve a spot at every Thursday evening yoga class for the next month. Click the OK button, to accept cookies on this website. A sunk cost is an amount that has already been spent and cannot be recovered. Sunk Costs can prove to be a barrier to exit as management try to recoup those costs back instead of cutting their losses. The Uncomfortable Boots. You pay it without any expectation of having that money returned to you. If a firm invests in a high profile project, it may be better to make continued losses rather than the reputational harm of admitting it made a failure. But the sunk cost fallacy also influences how we conduct business. While you did spend the money already, you can't get it back whether you go to the concert or not. It is within human nature to fiercely despise losses. It is better to throw away the last two cakes. Fiscal responsibility isn't about completely avoiding them, but knowing how to mitigate the damage. Sometimes you aren't sure if you should throw in the towel or not. Try to make better and more informed decisions by exploring your options so you can minimize your tendency to base your choices on financial and emotional investments that cannot be recovered. When the financial growth of a business is uncertain going forward, the decision to keep going shouldn't be based on the time and money already spent. Say you bought tickets to see a band play in your town, but you wake up sick on the day of the concert. Doing these things will help you act with more clarity so you can make decisions that are based on your vision rather than your sunk cost. False! “I might as well keep pouring more money into this venture because I already invested a lot.”. In business, a sunk cost fallacy can cost a business greater financial losses. Say for example you’ve bought some of our local stocks over the past few years that have performed really badly because their business models have been fundamentally disrupted. If the examples we discussed above didn’t resonate with you, you can likely relate to this one. So it doesn’t matter which option is chosen – the tickets will still be a waste. It is commonly known as the Sunk-Cost Fallacy or the Escalation of Commitment. The sunk costs here may be time, the effort it took to go to the movie, the cost of the ticket and your popcorn, etc. You want to avoid making decisions that are based only on the present moment without looking at what is best for your future. Hi Tejvan, When we make decisions at the margin, we discount any sunk costs. If something is not working, you have to know when it is time to throw in the towel.