The sunk cost effect is an irrational choice made because we are reluctant to spend money that has already been spent. Why do we make these choices, whether it be for baseball games, movies, or investments? Let’s look at the psychology and causes of sunk costs.
When you enter a baseball stadium, should you watch the game to the end?
To enter the ballpark, you must pay and purchase a ticket. However, the team you support may not always do well. Let’s say your favorite team is playing poorly and is losing by a large margin from the start of the game. In this case, it might be a good idea to leave the stadium before the end of the game. However, there are many cases where people think they should see the show to the end because they don’t want to waste the ticket price. Is this the right idea?
If you are obsessed with sunk costs, you will make the wrong choice
Sunk cost literally means the cost that cannot be recovered because it has sunk deep into the sea. It is an important principle not to consider sunk costs when making decisions because they cannot be recovered. When making any investment or business decision, you must decide whether to continue or discontinue it. The decision is made after comparing the profits and losses that can be obtained by continuing with the profits and losses that can be obtained by discontinuing. However, sunk costs that cannot be recovered from the costs already spent will become expenses regardless of such decisions.
Therefore, sunk costs should not be considered when making decisions. No matter how large the sunk cost is, it is irrelevant to decision-making because it is treated as a cost regardless of whether the business continues or not. Only the part where the magnitude of benefits and costs changes according to various other decisions affects the decision, while sunk costs do not affect future changes in benefits and costs.
Let’s go back to the story of the baseball stadium. When deciding whether to leave the stadium during a game or to watch the entire baseball game, you should focus on the difference between the two options by comparing the advantages of continuing to watch the game and not watching it to the end. In other words, to make a good decision, you should compare “I’ll watch the whole game because my team might win in the end” and “I’d rather do something else at this time and it would be more fun.” Continuing to watch baseball because of the ticket price is a wrong choice because it involves sunk costs.
Psychological factors of sunk costs
The issues related to sunk costs are related to various psychological characteristics, one of which is the psychological tendency to deny that something has failed. Success and failure, profit and loss, caused by any decision, are affected by good decisions and bad decisions, and by whether or not one makes an effort, but fundamentally, future events are affected by uncertainty, or luck. Anyone can fail. However, people usually take failure to admit that they have suffered a loss, so they overestimate the possibility of success when they do not want to admit failure. Therefore, the greater the sunk cost, the more likely they are to hold on a little longer and, if things work out, to evaluate the possibility of gaining benefits that exceed the sunk cost as higher.
When investing in stocks, you should not focus on how much you paid for them, but rather on the future movement of the stock price. However, when making an investment, people are often emotionally influenced by the return on investment compared to the purchase price and hold on to the investment until they recover their investment. When gambling, it is easy to lose more money if you continue to play without admitting losses and trying to recover your principal.
The sunk cost fallacy also comes into play when it comes to deciding the price of a product to be sold. Suppliers should set prices taking into account all factors, including the conditions of the demand and the production costs according to the production volume. However, if one is obsessed with the idea that “failure is unacceptable and one must make a profit at all costs” and “one must recover sunk costs,” one may make the wrong decision to set a price higher than the appropriate price based solely on the supplier’s situation, ignoring the situation of the consumer. In reality, the loss can be reduced by lowering the price slightly, but the company considers this to be a failure and keeps the price high, which further increases the damage.
In a similar case, even though the price of the house is falling, the landlord is holding out by paying high interest, or the building owner is trying to get high rents to break even, and is holding out for a tenant who will accept the rent someday, which is why the vacancy rate is prolonged. If you hold on, there is a possibility that it will turn out to be a profit, but there is a higher probability that you will suffer a greater loss.
Sunk costs differ between long-term and short-term
There are two types of costs in business: fixed costs that are incurred at all times and variable costs that vary depending on sales. In the short term, fixed costs are always spent. Therefore, in short-term decision-making, fixed costs have the nature of sunk costs. However, if you take more time to think about it, you can decide whether to expand the business, continue it, or give up and withdraw. At this point, some of the fixed costs become sunk costs and some can be recovered.
Let’s say you run a cafe. When deciding whether to continue to operate during the holiday period (short-term decision), the rent for the store that has already been contracted cannot be returned even if the store is closed during the holiday period, so the rent at this time has the nature of sunk cost. However, when deciding whether to close a cafe that is not doing well (a long-term decision), you must consider the length of the lease. However, the cost of interior design is a sunk cost that cannot be recovered even if the business closes, so it should not be considered.
Fixed costs may not be sunk costs in the long term due to their nature, and may not be sunk costs depending on whether they are covered by a contract with the head office or whether they are protected by law. So, strictly speaking, this time it is not a sunk cost, but because of the uncertainty, the expression “sunk cost” is often used. This characteristic is what causes cases of uncertainty in whether the sunk costs in an economic sense actually exist.
Let’s go to the gym, using the psychology of sunk costs
At the beginning of the year, quite a few people eagerly sign up for a gym membership and then stop going regularly a few days later. According to a survey, 71 percent of respondents said they give up on exercising. At this point, the registration fee for the health club has already been paid and cannot be refunded, so it is a sunk cost, and the gym is not used because only immediate benefits and losses are considered. However, this is an act of rationalizing oneself with the logic of sunk costs because one hates and finds exercise too tiresome.
In reality, decision-making is influenced by momentary emotions and it is easy to neglect what is beneficial for me in the long run. For example, the health benefits of exercise are long-term, so they are easy to underestimate, while the immediate annoyance and laziness are easy to overestimate. Also, the sunk cost fallacy is actually valid, so it fits perfectly into the rationalization. However, it is better to accurately assess the value of health gained through exercise and exercise.
In such cases, it is better to lead yourself in the direction of going to the gym because it is better to save money than to think that it is a sunk cost and do whatever you want. It is a kind of self-restraining contract that uses the psychology of sunk costs. Including sunk costs in decision-making is an irrational decision, but it can ultimately lead me to a better outcome.
There are various cases where we can think about sunk costs, but the fundamental cause of the controversy over sunk costs is when we look back on something we decided in the past and find that we are losing money or that things have not gone as planned. So, there may be sunk costs in the subconscious mind that want to deny their own failures or mistakes.
The first way to deal with the sunk cost problem is to not take sunk costs into account when making decisions, and the more fundamental way is to not create situations where sunk costs are a concern. In other words, when making a decision at the beginning, make the decision as carefully as possible to reduce the possibility of regret or failure later. If we learn from failure beyond admitting failure and reducing damage, we can reduce the possibility of failure.
