What is Sunk Cost Dilemma?
Sunk cost dilemma is a formal economic term that describes the emotional difficulty of deciding whether to proceed with or abandon a project when time and money have already been spent, but the desired results have not been achieved.
A sunk cost dilemma, when attempted to be resolved, requires an evaluation of whether further investment would just be throwing good money after bad. The purely rational economic person would consider only the variable costs, but most people irrationally factor the sunk costs into our decisions. Sunk cost dilemma is also called the Concorde Fallacy.
- The sunk cost dilemma refers to emotional difficulty of deciding whether to proceed or abandon a failed project.
- The dilemma is applicable to past decisions, in which time and resources have already been expended, as well as future decisions, in which time and resources will be expended based on past results.
- Rational thinking dictates that we should avoid taking sunk costs into account when deciding a future course of action.
Understanding Sunk Cost Dilemma
Sunk costs are expenditures that can't be recovered. For example, if you decide halfway through installing new hardwood flooring in your house that you hate the way it looks, you have a sunk cost.
You can't return the flooring that's already been laid down. The dilemma is whether to install the rest of the flooring and hope you learn to love it because you hate the thought of losing the money you've already spent, or whether to accept the sunk cost, tear up the new wood floors and buy another type of flooring.
Sunk costs can happen both in the past and in the future. Let's say you buy something from the store. The store receipt shows the refund period, or the number of days you have to change your mind and make a return and get your money back. This period is known as the retrievable cost because you still have time the retrieve your money from the store. If you've passed that period—some may give you as many as 90 days to get a refund—then you may not be able to get a refund, resulting in a sunk cost.
But how does a sunk cost relate to a situation in the future when you haven't spent the money yet? That's easy. Consider post-paid cell phone, or cable and internet services. When you sign up, you'll probably be under a contract to lock in your monthly rate. Most of these companies require a minimum time for you to stay with the service, mainly to keep you from jumping ship to a competitor who may offer you a better deal later on. If you move or decide to cancel your service before your contract is up, you may have to pay out the rest of your contract. This money is called a sunk cost.
Sunk Cost Dilemma and Rationality
Let's take a look at how the sunk cost dilemma works and how it relates to rational thinking. The sunk cost dilemma puts people at a crossroads. The dilemma comes into effect when you consider money you've already spent, as well as money that will be spent in the future. It's not financially prudent to walk away from something because of the money you've put into the decision, but you also can't walk away because doing so will cost you more money as well.
Let's say a homeowner decides to do renovations on his home. The contractor does a walk through with the owner, discusses the project requirements, and quotes a total construction price of $100,000 to complete the job. The renovations will take six months to complete. Both parties agree, and the homeowner puts down 25% or $25,000 down. After the second month of work, the contractor finds a problem with the foundation, and tells the homeowner he will need to increase the original price by another $30,000. The homeowner now faces the dilemma of walking away from the job and losing the $25,000 he's already spent, or spend the extra $30,000—on top of the remaining $75,000—to complete the job.
There are two variables at play here. The homeowner can't necessarily discount the sunk costs, which tends to be a rational thought process. Doing so means he falls into the sunk cost dilemma. But if he chooses to overlook the sunk costs, he falls into the sunk cost trap or the sunk cost fallacy. This happens when he makes an irrational decision, one made without considering the money he's already spent.
Example of Sunk Cost Dilemma
Thomas Edison, inventor of the light bulb, was finding it difficult to carve out a market for his electric lamps in the 1880s. As a result, his manufacturing plant was not operating at full capacity and the cost to produce an electric lamp was expensive.
Instead of abandoning his product for a new line or strategy, Edison decided to double down on them. He ramped up his manufacturing to full capacity to focus on volume. Increasing his manufacturing capacity added 2% to Edison's operational costs while allowing him to make 25% more product.
The newly-made lamps were sold in Europe for a cost that was significantly higher than manufacturing cost. His sunk costs in manufacturing enabled Edison to increase manufacturing output quickly. But he made a rational decision to pursue a future course of action independent of the sunk costs and irrespective of the fact that his electric lamps were not doing well in the US market.