Sunk cost

In economics and business decision-making, a sunk cost is a cost that has already been incurred and cannot be recovered (also known as retrospective cost).

Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. In that regard, both retrospective and prospective costs could be either fixed costs (continuous for as long as the business is in operation and unaffected by output volume) or variable costs (dependent on volume).[1] However, many economists consider it a mistake to classify sunk costs as "fixed" or "variable." For example, if a firm sinks $400 million on an enterprise software installation, that cost is "sunk" because it was a one-time expense and cannot be recovered once spent. A "fixed" cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the software. The upfront irretrievable payment for the installation should not be deemed a "fixed" cost, with its cost spread out over time. Sunk costs should be kept separate. The "variable costs" for this project might include data centre power usage, for example.

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. The fields of traditional economics propose that economic actors should not let sunk costs influence their decisions. Doing so would not be rationally assessing a decision exclusively on its own merits. Alternatively, a decision-maker might make rational decisions according to their own incentives, outside of efficiency or profitability. This is considered to be an incentive problem and is distinct from a sunk cost problem. Evidence from behavioral economics suggests this theory may fail to predict real-world behavior. Sunk costs do, in fact, influence actors' decisions because humans are prone to loss aversion and framing effects.

Sunk costs should not affect the rational decision-maker's best choice. However, until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes.

For instance, if someone is considering preordering movie tickets, but has not actually purchased them yet, the cost remains avoidable. However, if the price of the tickets rises to an amount that requires him or her to pay more than the value he or she places on them, they should figure out the change in terms of prospective cost that goes into the decision-making process and re-evaluate his decision hence.

Description

The sunk cost is distinct from economic loss. For example, when a new car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, then it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which is no longer relevant to decisions about the future; it may be used inconsistently in quantitative terms as the original cost or the expected economic loss. It may also be used as shorthand for an error in analysis due to the sunk cost fallacy, irrational decision-making or, most simply, as irrelevant data.

Economists argue that sunk costs are not taken into account when making rational decisions. In the case of a baseball game ticket that has already been purchased, the ticket-buyer can choose between the following two end results if he realizes that he doesn't like the game:

  1. Having paid the price of the ticket and having suffered watching a game that he does not want to see, or;
  2. Having paid the price of the ticket and having used the time to do something more fun.

In either case, the ticket-buyer has paid the price of the ticket so that part of the decision no longer affects the future. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the game at all, regardless of the price, just as if he were to go to a free baseball game. The economist will suggest that, since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.

Sunk costs may cause cost overrun. In business, an example of sunk costs may be investment into a factory or research that now has a lower value or no value whatsoever. For example, $20 million has been spent on building a power plant; the value at present is zero because it is incomplete (and no sale or recovery is feasible). The plant can be completed for an additional $10 million, or abandoned and a different but equally valuable facility built for $5 million. It should be obvious that abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss of the original expenditure—the original sum invested is a sunk cost. If decision-makers are irrational or have the wrong incentives, the completion of the project may be chosen. For example, politicians or managers may have more incentive to avoid the appearance of a total loss. In practice, there is considerable ambiguity and uncertainty in such cases, and decisions may in retrospect appear irrational that were, at the time, reasonable to the economic actors involved and in the context of their own incentives.

Behavioral economics recognizes that sunk costs often affect economic decisions due to loss aversion: the price paid becomes a benchmark for the value, whereas the price paid should be irrelevant. This is considered irrational behavior (as rationality is defined by classical economics). Economic experiments have shown that the sunk cost fallacy and loss aversion are common; hence economic rationality—as assumed by much of economics—is limited. This has enormous implications[example needed] for finance, economics, and securities markets in particular. Daniel Kahneman won the Nobel Prize in Economics in part for his extensive work in this area with his collaborator, Amos Tversky.

Other Languages
العربية: تكلفة غارقة
español: Costo hundido
한국어: 매몰 비용
Nederlands: Sunk costs
日本語: 埋没費用
Tiếng Việt: Chi phí chìm
粵語: 旁置成本
中文: 沉没成本