The sunk cost effect—making irrational choices because we feel bad about money already spent. Why do we make these choices in baseball games, movies, investments, and more? Let’s explore the psychology and causes of sunk costs.
Once you enter the baseball stadium, should you stay until the end of the game?
To enter the stadium, you pay money and buy a ticket. But your favorite team can’t always perform well. Consider a scenario where your favorite team is struggling early in the game and trailing by a large margin. In this case, leaving the stadium mid-game instead of watching until the end could be a good choice. However, many people think, “I paid for the ticket, so I should watch until the end.” Is this the right way to think?
Fixating on sunk costs leads to poor choices
Sunk cost literally means a cost that is deeply sunk in the sea and cannot be retrieved. Since sunk costs cannot be recovered, it is a crucial principle not to consider them when making decisions. Suppose you must decide whether to continue or discontinue an investment or business venture. The decision is made by comparing the benefits and losses gained by continuing versus those gained by discontinuing. However, among the costs already incurred, sunk costs that cannot be recovered become expenses regardless of this decision.
Therefore, it is correct not to consider sunk costs when making a decision. No matter how large the sunk cost, it is treated as an expense regardless of whether the business continues, making it irrelevant to the decision. Only the portion where the magnitude of benefits and costs changes based on various different decisions influences the choice; sunk costs cannot affect future changes in benefits and costs.
Let’s return to the baseball stadium example. To decide whether to leave the stadium mid-game or stay to watch the entire baseball game, one must compare the advantages of continuing to watch versus leaving early, focusing on the difference between the two choices. In other words, to make a good decision, you should compare ‘Staying to watch because our team might come back and win’ versus ‘Doing something else with this time would be more enjoyable’. Staying to watch baseball because you feel bad about wasting the ticket price is a choice influenced by sunk costs, making it a poor decision.
The Psychological Factors of Sunk Costs
The problems associated with sunk costs stem from several psychological traits, one being the reluctance to admit failure. Success or failure, profit or loss from any decision is influenced by whether it was a good or bad decision and the effort put in, but fundamentally, future events are subject to uncertainty—that is, luck. Anyone can fail. However, people often perceive admitting a loss as admitting failure. Therefore, when unwilling to admit failure, they tend to overestimate the likelihood of success. Consequently, the larger the sunk cost, the more likely one is to hold on longer, overestimating the potential for future gains to exceed the sunk cost.
When investing in stocks, one should focus on future stock price movements, not the purchase price. Yet when investing, people are often emotionally swayed by how much their current return is relative to their original purchase price, leading them to hold onto the investment until they break even. Similarly, in gambling, refusing to admit losses and continuing until the original stake is recovered often leads to even greater losses.
Sunk cost psychology also becomes problematic when setting the price for a product to sell. Suppliers should set prices considering all factors, including the buyer’s circumstances and production costs based on output. However, if they become fixated on obsessions like ‘failure is unacceptable, profit must be made at all costs’ or ‘the sunk costs must be recovered,’ they may make flawed decisions. They might set prices higher than appropriate, based solely on their own situation and ignoring the buyer’s circumstances. In reality, lowering the price slightly could reduce losses, but viewing that as failure leads them to maintain high prices, ultimately causing greater damage.
A similar case occurs when homeowners persist in paying high interest rates despite falling house prices, or when building owners demand high rents to recoup their investment, stubbornly waiting for a tenant who will accept that rent, only to face prolonged vacancies. While persistence might eventually yield gains, the probability of incurring greater losses is higher.
Sunk costs differ between long-term and short-term perspectives
Business costs consist of fixed costs that always occur and variable costs that fluctuate with sales volume. In the short term, fixed costs are always incurred. Therefore, in short-term decision-making, fixed costs have the nature of sunk costs. However, when considering a longer time horizon—whether to expand, continue, or abandon and withdraw the business—some fixed costs become sunk costs while others become recoverable.
Consider operating a cafe. When deciding whether to close or remain open during a holiday period (a short-term decision), the rent already contracted for the holiday period cannot be refunded, so the rent takes on the nature of a sunk cost. However, when deciding whether to close an unprofitable cafe (a long-term decision), the duration of the lease agreement must be considered. However, the costs invested in the cafe’s interior design are sunk costs that should not be considered, as they are difficult to recover even if the business closes.
Fixed costs, by their nature, may not be sunk costs in the long term. They may also not be sunk costs if compensation is possible based on contracts with headquarters or legal protections. Therefore, strictly speaking, they shouldn’t be called sunk costs, but the term is often used due to the inherent uncertainty. These characteristics lead to situations where it is uncertain whether costs truly qualify as sunk costs in the economic sense.
Leveraging the psychology of sunk costs: Let’s go to the gym
Many people enthusiastically sign up for gym memberships at the start of the new year, only to stop going properly after a few days. According to one survey, 71 percent of respondents said they give up exercising. The gym registration fee is already paid and non-refundable, making it a sunk cost. People stop going to the gym because they only weigh immediate gains and losses. However, this is behavior where someone dislikes exercise so much and finds it so bothersome that they rationalize their inaction using the sunk cost logic.
Real-world decision-making is easily swayed by momentary emotions and tends to neglect what benefits us long-term. For instance, the health gained through exercise is long-term and thus easy to undervalue, while the immediate hassle and laziness feel overwhelmingly important. Furthermore, the sunk cost logic is actually quite valid, making it a perfect fit for rationalization. However, it’s better to accurately assess the value of the health gained through exercise and actually go work out.
In such situations, rather than thinking “I’ll just do whatever I want because of sunk costs,” it’s better to guide myself toward going to the gym because I don’t want to lose what I’ve already invested. This is essentially using the psychology of sunk costs to create a kind of self-binding contract. Including sunk costs in decision-making is an irrational choice, but it can ultimately lead to better outcomes for myself.
While there are various situations where sunk costs can be considered, the fundamental reason sunk costs become controversial is when, upon belatedly reviewing a past decision, one sees a loss or finds things didn’t go as planned. Thus, sunk costs may linger in the mind from an unconscious desire to deny one’s own failure or mistake.
The first way to effectively handle the sunk cost problem is to not factor it into your decision-making. A more fundamental approach is to avoid creating situations where you have to grapple with sunk costs in the first place. That is, when making any decision initially, be as careful as possible to minimize the likelihood of later regret or failure. Beyond acknowledging failure and minimizing damage, learning from failure can even reduce the probability of failure itself.
