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 man 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.
BREAKING DOWN 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.