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Sunk cost
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Sunk cost
In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, people in everyday life often take previous expenditures in situations, such as repairing a car or house, into their future decisions regarding those properties.
According to classical economics and standard microeconomic theory, only prospective (future) costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. The only things that matter are the future consequences. Past mistakes are irrelevant. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. They may be described as "water under the bridge", and making decisions on their basis may be described as "crying over spilt milk". In other words, people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions. Thus, if a new factory was originally projected to cost $100 million, and yield $120 million in value, and after $30 million is spent on it the value projection falls to $65 million, the company should abandon the project rather than spending an additional $70 million to complete it. Conversely, if the value projection falls to $75 million, the company, as a rational actor, should continue the project. This is known as the bygones principle or the marginal principle.
The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Expected utility theory relies on a property known as cancellation, which says that it is rational in decision-making to disregard (cancel) any state of the world that yields the same outcome regardless of one's choice. Past decisions—including sunk costs—meet that criterion.
The bygones principle can also be formalised as the notion of "separability". Separability requires agents to take decisions by comparing the available options in eventualities that can still occur, uninfluenced by how the current situation was reached or by eventualities that are precluded by that history. In the language of decision trees, it requires the agent's choice at a particular choice node to be independent of unreachable parts of the tree. This formulation makes clear how central the principle is to standard economic theory by, for example, founding the folding-back algorithm for individual sequential decisions and game-theoretical concepts such as sub-game perfection.
Until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making process. For instance, if someone is considering pre-ordering movie tickets, but has not actually purchased them yet, the cost remains avoidable.
Both retrospective and prospective costs could be either fixed costs (continuous for as long as the business is operating and unaffected by output volume) or variable costs (dependent on volume). However, many economists[who?] 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.
There are cases in which taking sunk costs into account in decision-making, violating the bygones principle, is rational. For example, for a manager who wishes to be perceived as persevering in the face of adversity, or to avoid blame for earlier mistakes, it may be rational to persist with a project for personal reasons even if it is not the benefit of their company. Or, if they hold private information about the undesirability of abandoning a project, it is fully rational to persist with a project that outsiders think displays the fallacy of sunk cost.
The bygones principle does not always accord with real-world behavior. Sunk costs often influence people's decisions, with people believing that investments (i.e., sunk costs) justify further expenditures. People demonstrate "a greater tendency to continue an endeavor once an investment in money, effort, or time has been made". This is the sunk cost fallacy, and such behavior may be described as "throwing good money after bad", while refusing to succumb to what may be described as "cutting one's losses". People can remain in failing relationships because they "have already invested too much to leave". Other people are swayed by arguments that a war must continue because lives will have been sacrificed in vain unless victory is achieved. Individuals caught up in psychologically manipulative scams will continue investing time, money and emotional energy into the project, despite doubts or suspicions that something is not right. These types of behaviour do not seem to accord with rational choice theory and are often classified as behavioural errors.
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Sunk cost
In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, people in everyday life often take previous expenditures in situations, such as repairing a car or house, into their future decisions regarding those properties.
According to classical economics and standard microeconomic theory, only prospective (future) costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. The only things that matter are the future consequences. Past mistakes are irrelevant. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. They may be described as "water under the bridge", and making decisions on their basis may be described as "crying over spilt milk". In other words, people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions. Thus, if a new factory was originally projected to cost $100 million, and yield $120 million in value, and after $30 million is spent on it the value projection falls to $65 million, the company should abandon the project rather than spending an additional $70 million to complete it. Conversely, if the value projection falls to $75 million, the company, as a rational actor, should continue the project. This is known as the bygones principle or the marginal principle.
The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Expected utility theory relies on a property known as cancellation, which says that it is rational in decision-making to disregard (cancel) any state of the world that yields the same outcome regardless of one's choice. Past decisions—including sunk costs—meet that criterion.
The bygones principle can also be formalised as the notion of "separability". Separability requires agents to take decisions by comparing the available options in eventualities that can still occur, uninfluenced by how the current situation was reached or by eventualities that are precluded by that history. In the language of decision trees, it requires the agent's choice at a particular choice node to be independent of unreachable parts of the tree. This formulation makes clear how central the principle is to standard economic theory by, for example, founding the folding-back algorithm for individual sequential decisions and game-theoretical concepts such as sub-game perfection.
Until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making process. For instance, if someone is considering pre-ordering movie tickets, but has not actually purchased them yet, the cost remains avoidable.
Both retrospective and prospective costs could be either fixed costs (continuous for as long as the business is operating and unaffected by output volume) or variable costs (dependent on volume). However, many economists[who?] 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.
There are cases in which taking sunk costs into account in decision-making, violating the bygones principle, is rational. For example, for a manager who wishes to be perceived as persevering in the face of adversity, or to avoid blame for earlier mistakes, it may be rational to persist with a project for personal reasons even if it is not the benefit of their company. Or, if they hold private information about the undesirability of abandoning a project, it is fully rational to persist with a project that outsiders think displays the fallacy of sunk cost.
The bygones principle does not always accord with real-world behavior. Sunk costs often influence people's decisions, with people believing that investments (i.e., sunk costs) justify further expenditures. People demonstrate "a greater tendency to continue an endeavor once an investment in money, effort, or time has been made". This is the sunk cost fallacy, and such behavior may be described as "throwing good money after bad", while refusing to succumb to what may be described as "cutting one's losses". People can remain in failing relationships because they "have already invested too much to leave". Other people are swayed by arguments that a war must continue because lives will have been sacrificed in vain unless victory is achieved. Individuals caught up in psychologically manipulative scams will continue investing time, money and emotional energy into the project, despite doubts or suspicions that something is not right. These types of behaviour do not seem to accord with rational choice theory and are often classified as behavioural errors.