The Sunk Cost Fallacy

  “If you’ve ever held on to a pair of shoes that make your feet ache or a pair of pants that no longer fit you for no other reason than you paid a lot of money for them, you’ve experienced the sunk-cost bias.”

In both business and personal finance, fiscal responsibility is constantly preached to help you avoid losing more money than necessary. But sometimes there is simply money that is going to be lost, irresponsibly or not. Such costs are sunk costs and are bound to happen, and while you should know how to avoid them when possible, it is equally if not more important to understand how to prepare for them and possibly even budget around them. But first, what is a sunk cost?    

A sunk cost is a cost that has already been incurred and cannot be recovered. In other words, a sunk cost is an expense from the past that is no longer relevant to decisions about the future. This concept is quite well comprehended in the phrase “Let bygones be bygones”. In decision making, sunk costs are not usually taken into account when deciding whether to continue an investment project or not. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, in everyday life, people often take previous expenditures in situations such as repairing consumer durables or house into their future decisions regarding those properties.

According to standard economic theory, when we force down our throats a particularly unpalatable dish simply because it was rather expensive, we behave irrationally. A movie studio spends $50 million on making a movie and an additional $20 million on advertising. But the film disappoints at the box office and grosses just $15 million. Any of that budget that isn’t getting recouped is a sunk cost!

Sunk cost is popularly also known as the Concorde Fallacy, named after one of the most infamous public examples of the sunk cost fallacy in action. The Concorde was the first commercial supersonic aircraft commissioned by the British and French governments. It was designed to manufacture aircrafts for the public at supersonic speeds allowing passengers to cross the Atlantic in 3 & 1/2 hours. The Concorde however was predicted to be a failure early on and both the French and British governments were aware about it. However, this didn’t stop sunk costs from rearing their ugly head as both governments continued to fund the project because of the psychological and financial investment they had already made into it. Eventually, and inevitably, the Concorde did fail, but not before incurring additional losses by both contributing governments.

A recurring theme with all of these sunk costs is inevitability. Businesses have to update their equipment. They have to spend on research and advertising regardless of if the product succeeds or fails.

Now, honouring sunk costs is not necessarily non-optimizing or irrational behaviour. Just as it is important to understand the costs that should be considered in decision making, it is important to understand what costs should not. Consider the two options you may have when you wake up – do you work out or sleep in? Have you ever convinced yourself to get out of bed by reminding yourself that you paid $100 for your monthly gym membership? Well, you fell victim to this common logical fallacy.

When taking certain decisions, we consciously decide to take into account certain sunk costs to bind ourselves into doing something we deem undesirable yet beneficial. Going to the gym and exercising regularly, is a painfully strenuous and arduous resolution to keep. It is a huge investment of time, effort not to mention the pain of stretched, sore muscles. And yet, it is known that going to the gym is highly beneficial to our bodies. Not only does it boost your energy, increase lean muscle mass, decrease your risk for certain health conditions and help you manage your weight, but it also improves your mood and enables you to live longer. Sounds pretty amazing, right?  So how do I ensure that I end up in the gym every morning?

Simple and straightforward, I just pay my yearly gym subscription at the inception of every year! Since I know that I have already paid a massive amount, which is absolutely non-reimbursable, it gives me an incentive and that much needed push to get me to the gym every morning. Reminding myself of a cost that is certainly sunk, but a cost that helps me stay fit and healthy for the foreseeable future.

There are a number of illustrations where individuals have benefited by not ignoring the sunk cost. That being said, incentivizing commitment through costs can be a dangerous game to play. Aspects of your good that demand a customer’s effort, time or money can easily turn purchasers away from your brand before those costs have a chance to motivate them.

For example, a brand executive trying to implement the sunk cost methodology might create a membership program where customers have to purchase in so that they can earn discounts and special offers. Once a customer buys in, the sunk cost effect triggers and motivates the customer to take advantage of the special exciting offers in order to not “lose” their buy-in fee. The stumbling block here is that price sensitive customers may be discouraged by the fee and decide not to opt-in in the first place which leaves no room for the sunk cost principle to stimulate their actions.

The same situation occurs when brands create effort or time costs that a customer has to incur to use their product. For example, if your service has a steep learning curve, customers have to invest time and energy to figure out how to use it effectively. When they are successful this investment can create a psychological lock-in for your brand but be aware a steep learning curve can also lead to customer vexation. Such is the risk involved in sunk costs. When they work, they work but these options can be a costly turn-off that lessen adoption and a customer’s enjoyment of the service.

The question then remains: how can a brand utilize the sunk cost methodology without forcing their customers to bear an unwanted burden? The answer to this is that the brand can create a “sunk reward” instead.

It’s easy to see this reversal of the sunk cost fallacy and even effortless to put this principle into action. Instead of forcing customers to bear a financial burden, give them a stake in the game through rewards. A simple points-based program or a tiered membership can give customers financial and emotional rewards they will be stimulated to make the most of. Ergo, your customers are choosing between you and the competition. The rewards you give them can be that little push in the right direction to assist them make the right decision.

Using rewards to motivate your customers plays to the sunk cost fallacy without misleading or deluding your customers. Like the Olympic athlete who perseveres because of the years they spent training, sunk rewards can motivate a customer to make the optimal decision by creating an investment in your product and allowing them to subsequently realize that reward. Rewards can also build strong emotional bonds with your customers because while the costs may be sunk a relation-ship never sinks.     

“The middle of the universe is tonight, is here. And everything behind is a sunk cost.” – Marina Keegan

– Robin Francis (Editor, Econ Declassified)

References

Fiorillo, S. (2018, November 05). Sunk Cost: Definition, Examples and Fallacy. Retrieved from https://www.thestreet.com/personal-finance/education/sunk-cost-14767636

Sunk cost. (2020, September 12). Retrieved from https://en.wikipedia.org/wiki/Sunk_cost

Sunk Cost Examples: Top 4 Examples with Explanation. (2020, July 20). Retrieved from https://www.wallstreetmojo.com/sunk-cost-examples/

7 Ways Sunk Cost Bias Can Boost Your Conversions. (2020, August 06). Retrieved from https://www.ventureharbour.com/sunk-cost-bias-7-ways-use-boost-conversions-examples/

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