Friday, November 18, 2011

Not-so-sunken costs?

I recently had to decide between going to a concert for which I’d already bought a ticket and attending a dinner party with friends. Initially I was compelled to “get my money’s worth” by going to the concert (it was too late to sell the ticket to someone else), in spite of the fact that I would have preferred to go to the dinner (if I hadn’t bought the ticket). According to the economic theory of sunk costs, however, choosing to go to the concert under these circumstances would have been irrational.

Once a good or service has been paid for, the future costs and benefits of actually making use of the purchase should be compared to the future costs and benefits of alternative options—the cost of the purchase, paid in the past, is “sunk” and should not factor into the decision. Suppose that neither the dinner nor the concert would cost me any additional money, but I predicted the enjoyment I would get from the dinner would exceed the potential enjoyment from the concert. Because the expected future benefit minus the (nonexistent) future cost of the dinner exceeded that of the concert, I chose to go to the dinner.

Choosing to ignore sunk costs, however, is not always easy, in part because it can be difficult to distinguish situations in which the cost is truly sunk from those in which it shouldn’t be written off entirely.

Suppose instead I had been asked to bring a bottle of wine to the dinner. In that case, the fact that I had already bought the ticket meant that I was choosing between a concert that would cost no additional money, and a dinner that would cost me the price of a bottle of wine (say $15). Though I would have had a definite preference for going to the dinner and paying $15 for wine over going to the concert and paying $20 for a ticket, it could have been the case that I preferred going to the concert (at no additional cost) to going to dinner (and spending additional money). Although the $20 I’d spent on the ticket was gone either way, it had made one of the options free without affecting the cost of the other option. This would be particularly meaningful if I had a monthly budget for semi-luxuries like concerts and wine, and having spent $20 on the concert, I couldn’t justify spending $15 on a bottle of wine.

The moral of the story is that while you should never consider the “sunk cost” in itself when making decisions, it is relevant to consider how the sunken payment may have altered your current set of options.

Discussion questions:

1. Think about how this kind of analysis would be important to a company that has already invested considerable capital in a project, but later finds a different project that would have been better to invest in. When deciding whether to abandon the first project to invest in the second, how should the money already invested in the first project affect or not affect the decision?

2. Can you think of examples of sunk costs in your life that you might be tempted to not ignore because it can be difficult psychologically to not use things you’ve purchased?

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