Tuesday 31 May 2011

Sunk Costs, Trashy Novels and Good Behaviour

Anyone working in finance is likely to be familiar with the concept of a ‘sunk cost,’ but the idea has some interesting wider applications.

The term describes an expense that has already occurred and should therefore not be considered when appraising the costs and benefits related to a possible investment or project. For example, if a pharmaceutical company has spent £500m developing a drug which would then cost £100m to manufacture and generate £400m in sales, the decision over whether to manufacture would be based only on the latter two figures: £400m sales less £100m costs would give a £300m profit. The £500m spent on development is considered a ‘sunk cost’ and so doesn’t form part of decision over whether to proceed. While in this example the outcome is clear, the concept of a ‘sunk cost’ is somewhat non-intuitive.

Outside of finance, the idea gets little recognition, but it can be just as useful in making decisions. Often people ignore the fact that an expense already incurred is a sunk cost, and as a result may not make the best use of their time or their cash. Have you ever done the following?

  • Been to a show or event or on a holiday just because you had bought the tickets, even when you didn’t feel like doing it anymore?
  • Sat through a movie you realised was rubbish or finishing read a book you weren’t enjoying, just for the sake of getting to the end?
  • At an ‘all-you-can-eat’ buffet, eaten so much you felt sick?

A clear indicator of someone ignoring a sunk cost is when they say, “but… I want to get my money’s worth.” But this is a logical fallacy if it means continuing with something you wouldn’t otherwise do.

On the flip side, the concept of a sunk cost can be used to encourage positive behaviour. In fact by realising that we feel compelled to “get our money’s worth” we can manipulate ourselves into healthy or beneficial activities. My favourite example of this is my monthly gym membership. Based on my average attendance at the gym twice a week, it would cost the same to either pay a monthly subscription (with unlimited use) or pay individually for session I attend.

From one point of view, paying ‘per session’ gives me added flexibility by not being tied into a monthly contract (in economic terms I have “option value”). However, I know that if I pay a marginal sum for each session this gives me a disincentive to go to the gym. And if I pay a monthly subscription, I feel compelled to go, in order to “get my money’s worth,” and so I'm using this little behavioural bias in my favour.

So next time you go to a buffet, just remember it’s “eat as much as you like” and not “eat as much as you can:” it’ll save you the indigestion and won’t cost you a penny more…

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