The Sunk Cost Fallacy-You Should Understand

The Sunk Cost Fallacy-You Should Understand

In financial management, sunk costs are costs embedded in the company's operations which have already been incurred, and would be irrelevant if analyzed for future choices. In more common terms, it is a form of expense where the outcome would not change even if considered as a variable in a situation. In behavioral economics, the sunk cost fallacy is a concept introducing a scenario where a consumer overextends on his/her commitment to a consumption activity, to the point where it stops being practical.

If you have tried eating at a buffet and pay $50 for the entrance, you may find yourself overeating to get your money's worth. You may be right in simpler situations. However, is there any chance you may have just cost yourself more? In this scenario, you have already incurred the $50, and you would be obliged to pay it either way. The choices you gave yourself involves getting your money's worth, or eat as you always have. In the first option, you may have gotten $50 worth of food into your body. However, did you save money overall? The answer is no. Chances are, you might have diabetes or hypertension. In this point of reference, you may even have to spend more on medicines just by eating more for $50. From a microeconomic standpoint, you may have just lost yourself some money in the process.

When weighing the sunk cost fallacy on a societal level, acting on sunk costs as if the outcome would change more often results in unfavorable consequences. When people overextend their commitment to consumption, there are points of losses in the overall economy which would not have been lost if one had not acted on the sunk cost. Consider the example above. Overeating at a buffet would require the cooking staff to cook more food. These ingredients and condiments could have been used for another busy day. You, on the other hand, have eaten more than you need, so the food you ate more than necessary has no direct benefit for you. The restaurant incurred a loss, with no benefit for the consumer, creating a deadweight loss.

While it may be logical to commit to some expenses, it may be better to weigh several options first, before acting on it. The sunk cost fallacy may seem to be a complicated concept, but it is a part of our daily lives, whether we care to admit it or not. Awareness of these situations may be able to help in future decisions.

1. Are all overextensions on commitments falling under the sunk cost fallacy?

The sunk cost fallacy is a situational concept. It does not apply to all situations of the same nature. Outcomes related to costs already spent on machines or structures may still be changed when committing to repairs and selling them for a higher price. Look at the circumstances. If the outcome would change, then it would not be bad.

2. Are all sunk costs wasted?

This is a common and understandable misconception in behavioral economics. Sunk costs are not exactly wasted expenses. These are expenses that are not relevant in future analyses and are therefore unchangeable. In the example used in the article, the $50 payment for the buffet gives you the right to eat, which is still a privilege. The point of waste is being overly committed to the sunk cost that it eventually costs more.

3. How do I prevent situations from falling under the concept of sunk cost fallacy?

You need to be able to identify the difference between saving and wasting. If it doesn't save you any money or resources, it probably isn't worth it. This way, you would be able to identify situations where you would be at the opposite of where you wanted to be.