Dealing with sunk costs

Consider this. You are at the airport and you have two mineral water bottles in your bag.

You got one bottle free at a seminar you attended early in the day while you bought the other the previous day.

You are allowed to take only one bottle through the airport security. Which one would you take?

If you are typical individual, you will most likely select the one that you bought!

Why? You paid for the bottle.

The pain of paying for it will force you to keep the bottle and discard the one that you got for free. But classical economists may not consider your decision as rational. After all, a bottle is a bottle.

It should not matter which one you keep, as long as the water quenches your thirst!

Concorde Effect

Your decision then is driven by what behavioural economists call as the Concorde Effect.

Years ago, the British and the French governments got together to build a supersonic passenger jet.

The two governments, however, realised that the venture was unviable even before the first jet was fully operational.

The initiative was nevertheless pursued because the governments had “sunk” too much money into the project.

That is why the behaviour is also called the sunk-cost fallacy. It refers to our tendency to decide based on past actions or sunk costs.

How does the sunk-cost fallacy affect our spending decisions?

Suppose you visit a restaurant where you get buffet meal for Rs 1,000 plus taxes. How much will you eat? The fixed price will most likely change your eating behaviour!

How? You may feel the need to “maximise” your consumption, having paid so much money for the food! As economists would state, you try to derive maximum value or utility for the price paid.

And that may be counter-productive- you overeat and feel sick later.

You may not agree with this point of view. Consider this. Suppose the entire meal is offered as an a la carte.

That is, the same meal is offered not as a buffet, but as separate dishes. You can choose to eat what you want and you will have to pay only for what you eat.

Will you eat as much as you would if it were offered as a buffet? Perhaps not. Importantly, you will not feel the urge to “maximise” your consumption. And that will help you enjoy the meal!

Concorde Effect is one of the reasons we take sub-optimal decisions on our company's projects. And what's more, we may suffer from such bias even with our investment decisions!

But that is a different discussion altogether.

(The author is the founder of Navera Consulting. He can be reached at enhancek@gmail.com )

COMMENT NOW