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Not long ago, a friend of mine was going to Spain for a month, but was making a stopover in Paris.  She had booked and paid for a place to sleep in a cheap hostel when she was offered to stay—for free—in an apartment owned by an acquaintance.  She told me, just before she left home that she was sorry she wasn't given the offer sooner as she would much prefer to stay in the apartment, but, alas, since she had already payed for the hostel, she would sleep there, because the money spent would otherwise be wasted.

Her decision was wrong, or, perhaps, more correctly speaking, irrational from the perspective of economics.  It is an example of sunk cost fallacy and loss aversion and it's a way of thinking that unfortunately isn't all that uncommon.  Because of it, people go through all kinds of self-inflicted misery instead of doing what is good for them.

If my friend from the (true) story above had given it a little more thought, she might have realized that regardless of whether she chooses the hostel or the apartment she still would have payed for the hostel, and no matter what she does she won't get the money back.  The cost of the hostel is sunk.

Because the cost remains incurred whatever she decides to do, it shouldn't influence her decision, and she should just ignore the cost henceforth. That is the main point of the idea of sunk cost:  When deciding on an issue you should only consider the future costs and the future benefits of the options and let bygones be bygones.

So, if you are watching a really poor movie on the telly and can't decide whether or not to turn it off, you shouldn't let the fact that you have already spent an hour on the thing influence your decision: Better to waste one hour on a poor movie than two.  In other words, cut your losses and don't throw good money after bad.

Another example is how a grocer might lower the prices on groceries when it is almost closing time; even to the point where it is obviously selling them at a loss.  This demonstrates that because the cost is sunk the price isn't influenced by it.  What matters is the supply and demand of the groceries. If the grocer does not make a profit, that is tough luck, and the next day, the grocer will probably buy less, or cheaper, groceries to sell to the customers.  Or go out of business.


Further reading:

  • www.fact-index.com/s/su/sunk_cost.html
  • www.marietta.edu/~delemeeg/expernom/s94.html