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.

Key Takeaways

  • 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 Cost Dilemma and Rationality

Costs incurred in the past are usually sunk costs, but not always. For example, if you buy a sweater for your daughter, you can return it and get a refund if it doesn’t fit. In this case, the cost is a retrievable cost rather than a sunk cost. It becomes a sunk cost only once the return period has expired.

Future costs can be sunk costs if they are, for all practical purposes, inevitable. If, for example, you sign a contract requiring you to pay $100 a month for a year, and the contract can't be voided, that $1,200 is a sunk cost due to the legal obligation to pay the money. While you could default or declare bankruptcy, that usually isn’t an option.

Costs that depend on the decisions you make are called avoidable costs. Before you buy a car, you have the option of avoiding that monthly loan payment. Once you sign, that payment becomes a sunk cost. Recurring or fixed costs, like salaries and loan payments, are often considered sunk costs, since your decision does nothing to prevent the cost.

Rational thinking dictates that we should ignore sunk costs when making a decision. The goal of a decision is to alter the course of the future. And since sunk costs cannot be changed, you should avoid taking those costs into account when deciding how to proceed.

However, humans aren't always rational. Believing that sunk costs should be taken into account when making a decision is called the sunk cost fallacy, a common mistake in decision-making. Ignoring sunk costs has its own problems though, namely, the sunk cost dilemma.

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.