Sunk Cost (Economics) - Explained
What is a Sunk Cost?
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What is a Sunk Cost?
A sunk cost is the money that has already been spent and cannot be retrieved. Traditional microeconomics theory proposes the sunk cost should not influence an investment decision as it is already gone, and the cost will remain the same irrespective of the outcome of the decision. Only the prospective or future cost should be considered while making an investment decision. The term was primarily used in the oil industry. The decision of abandoning or operating an oil well depends on the future cash flow it can generate and not on the cost of the digging of the well. The cost of digging has already been incurred and that cannot be recovered. So, while taking a decision about the well, that cost should not matter. The sunk cost is also known as stranded cost, retrospective cost, embedded cost or sunk capital.
How does a Sunk Cost Work?
The firms need to carefully consider all the relevant costs while making a business decision. However, the costs which have already been incurred should not influence the decision. Only the future costs and the revenues are to be compared to take a sound decision. A sunk cost is different from economic loss. Say for example a firm buys machinery and subsequently resell it. The selling price is lower than the purchase price. This difference (including the transaction cost) is calculated as the economic loss. Now the price originally paid for purchasing the machinery should not affect the future decision about the machinery. If the company thinks they can derive more value by selling the machinery than not selling, then it should be sold. This original purchase price should not affect this decision. Thus, a sunk cost is not a precise quantity, rather it is a term to describe the amount that is paid in the past and no more relevant for future decisions. Firms can have various suck costs including the cost of purchasing machinery and equipment and lease cost of the factory. These costs are excluded from a sell-or-process-further decision. For example, let's assume, Company X manufactures a certain type of bags. The production cost of the bag is $30, and they sell it in $90. Now they have got an improved design for the bag. The new design bags cost $45 per bag and the seeing price can be $130. Now the company needs to compare these costs and revenues to make the decision whether to go with the new design. The sunk costs of machinery and factory lease are not considered in this decision-making process.
Academic Research on Sunk Costs
- The psychology of sunk cost, Arkes, H. R., & Blumer, C. (1985). Organizational behavior and human decision processes, 35(1), 124-140. This paper analyzes the psychology of sunk cost and how it tends to influence future decisions. Data from several questionnaire-based studies are used in this research. It shows that people tend to continue an endeavor once they have invested money, effort or time in it. The studies show that people who have incurred a sunk cost in a project estimate more success rate of the project than the people who haven't incurred any such cost. Prior courses in economics do not lessen the sunk cost effect. Finally, it concludes, no social psychological theory can fully subsume the sunk cost effect.
- Sunk-cost hysteresis, Baldwin, R. (1989). In this paper the nature of sunk-cost hysteresis is characterized for a broad class of assumptions on the forcing variable process. Particularly, the rational or model consistent expectations are included in this class. The paper shows the problem of the firm with a quite general forcing variable process can be deducted to be formally identical to the iid case. It also suggests there are huge possibilities of sunk-cost hysteresis to various modifications of the basic suck cost model.
- Escalation errors and the sunk cost effect: An explanation based on reputation and information asymmetries, Kanodia, C., Bushman, R., & Dickhaut, J. (1989). Journal of Accounting research, 59-77. This paper analyzes the escalation errors and the sunk cost effect and presents an explanation on the basis of reputation and information asymmetric. This paper argues people tend to cling or even escalate errors once the sunk cost is incurred. If a production manager purchases production equipment with large investment, she/he is likely to continue using it even after finding out better equipment with lower operational cost. The rationale is they do not want to waste the money that has already been invested in the equipment. This paper attempts to explain this paradox of human behavior.
- Looking forward and looking back: Integrating completion and sunk-cost effects within an escalation-of-commitment progress decision., Moon, H. (2001). Journal of Applied psychology, 86(1), 104. Two conflicting frameworks are used for explaining the decision makers' tendency to escalate their commitment to a previous plan; one is sunk cost and the other is project completion. This paper argues both of these are independent and interactive on the level of commitment of a decision maker. A total of 340 respondents participated in the study. Their responses were analyzed to find a complementary relation between the two frameworks.
- The role of probability of success estimates in the sunk cost effect, Arkes, H. R., & Hutzel, L. (2000). Journal of Behavioral Decision Making, 13(3), 295-306. Arkes and Blumer established once an investment is made in an endeavor people will tend to estimate a greater rate of success for the project. This paper conducts experiments to find out whether this inflated rate is a cause of the sunk cost effect, a consequence of the effect, or both? Two experiments were held in this regard and the first one suggests that inflation is not necessary for the effect to occur. The second experiment shows that the inflated estimate is a consequence of the decision to invest.
- The effect of windfall gains on the sunk-cost effect, Soman, D., & Cheema, A. (2001). Marketing Letters, 12(1), 51-62. This paper conducted a series of experiments to show the sunk cost effect may decline or sometimes may even disappear if a decision maker receives a windfall (unexpected) income at the time of making the decision. It shows this relationship is moderated by the similarity between the nature of the income and the suck cost. The paper argues in the mental account people may have the discretion to move money from one account to the other.
- Production and investment decisions under sunk cost and temporal uncertainty, Chavas, J. P. (1994). American Journal of Agricultural Economics, 76(1), 114-127. Sunk cost and temporal uncertainty are introduced in Jorgenson's neoclassical theory of investment, based on Glenn Johnson's asset fixity theory. Assuming the risk is neutral, this article shows the impact of suck cost and temporal risk on the implicit rental value of capital and investment and entry-exit decisions. The results show that a significant relationship exists between sunk cost and the impact of temporal uncertainty on production behavior.
- Innovative activity and sunk cost, Kaplan, T. R., Luski, I., & Wettstein, D. (2003). International Journal of Industrial Organization, 21(8), 1111-1133. This paper analyzes how time-dependent rewards and suck cost affect the decision of taking up an innovative activity. It suggests, when the firms are exactly of the same nature, taking up innovative activities slows down by a rise in the number of firms or a decline in the size of the rewards. Firms with higher profit potential are more prone to take up innovative activities. The framework of the study generalizes an all-pay auction; however, it shows that some qualitative different equilibrium behavior can be observed under certain circumstances.
- Sunkcost effects on purely behavioral investments, Cunha, Jr, M., & Caldieraro, F. (2009). Cognitive Science, 33(1), 105-113. When a monetary investment is concerned, the sunk cost effect is evident and well documented in the literature, however, the sunk cost effect is the cases of behavioral investments (such as time, effort, etc.) are not observed that clearly. A common explanation is, purely behavioral sunk-cost effects are difficult to book, track and balance in a mental account, thus it is not recorded. This paper argues, while deciding upon an alternative, people use effort-justification mechanism to account for behavioral resources invested, and then sunk cost effect may impact their decision. This claim is supported by the results of two experiments.
- Who throws good money after bad? Action vs. state orientation moderates the sunk cost fallacy, van Putten, M., Zeelenberg, M., & van Dijk, E. (2010). Judgment and Decision Making, 5(1), 33. People have different orientations (state and action) to cope with failing projects. This paper studies which of these two groups is more prone to fall prey to the sunk cost effect. The results show the people with a state orientation, who tend to ponder about the past and find it difficult to let it go are more likely to fall prey to the sunk cost effect. People with action orientation, who do not hold back the past, are less susceptible to the sunk cost effect. The implications of these results are discussed.
- A unified theory of market partitioning: an integration of resource-partitioning and sunk cost theories, Boone, C., & van Witteloostuijn, A. (2004). Industrial and corporate change, 13(5), 701-725. This paper aims to provide a unified theory of market partitioning. It integrates Glenn Carrroll's resource-partitioning and John Sutton's sunk cost theories to develop this framework. To buildup an understanding of the antecedents and consequences of so-called dual market structures, two theory fragments from organizational ecology and industrial organization are integrated. The paper argues these two theory fragments are complementary to each other and offer a different interpretation of the evolution of competition bringing out similar market structure outcomes.
- Optimal pricing with sunk cost and uncertainty, Alleman, J., & Rappoport, P. (2006). In The Economics of Online Markets and ICT Networks (pp. 143-155). Physica-Verlag HD. This article attempts to develop a model to determine optimal pricing. It identifies certain shortcoming of the pricing tools used by the regulators and proposes new methods. It also provides a literature review, describes the background issues and recommends a framework to address the concerns.