Episode 10: How Sunk Costs Work

One of, if not the most, important motivator in behavioral economics is the fear of loss. We’ve talked about this extensively and it takes many different shapes. One of my personal favorites is what’s known as a “sunk cost”.

Compared to a lot of behavioral economics terms this is pretty popular and well known, but just in case let me mind-journey for you.

You’re really hungry. It’s a hot Chicago summer day and you’ve had a long day at work.

On your walk home on the corner is a friendly neighborhood torta foodtruck. Oh my god. You love tortas. The thought of savory Mexican jamon (ham), topped with avocado and all the fixings with amazing green chili hot sauce and crema between bread carries you away. The smell hits you and you’re again reminded that there is a god. The cost is $8 for a sandwich. Even though you have leftovers at home that you can eat, you decide to stop and order one. You’re hungry and it’s after work; time to treat yourself (#treatyoself).

You wait in line, pay your $8 cash, and get your perfect torta. Warm juices of salsa and jamon dribble down the sides. Your mouth waters. However, unbeknownst to you, years of freezing ground has pushed up a part of the sidewalk by 3 inches. Your foot catches the ledge and your perfect torta flies out of your hand into a dirty puddle; gone forever.

You turn around and there’s now a line around the block to get another one. What do you do? If you had not just already stood in line for forever you would have been overjoyed to stand in line and pay $8 for a torta. But dejected you droop your head and go home to your leftovers.

Okay! Mind-journey over. What is interesting about that story is that if you wrote a computer program that would make decisions for you the calculation is different than what happened in real life.

You were hungry and willing to wait in line and pay money for a torta. You lost a torta so you didn’t eat one and are still just as hungry. Your situation hasn’t changed, and a computer program would say that humans would get back in line and wait again.

But your lost torta is a sunk cost. You paid for it, and it’s gone. In theory, sunk costs should have no impact on your next decision. It’s sunk, it’s gone. But, of course it has an impact on your decision-making process. It shouldn’t but it does.

It’s partially because we humans have a fear of loss, and partially because we have trouble segmenting time and decisions. We lump things together. So even though the calculation should be would I pay $8 for a torta, because we’ve already lost one we can’t help feeling like we’re paying $16 for one torta, even though that previous loss is immaterial to our next decision.

This effect creeps up all over the place. We’ll talk about it more later, with for example the gamblers fallacy, where gamblers feel that if they’re on a losing streak they should keep gambling because their luck is going to turn around…

Okay so how does this idea manifest itself? When humans make decisions, they can weigh the emotional experience of a sunk cost as value and make what on paper is an “irrational” choice. Or a choice that is against their own self-interest.

There are a lot of great papers about real life experiments demonstrating the effect. I’ll stick with one by Arkes and Blumer from 1985, The Psychology of Sunk Cost. They asked a series of questions. Here’s a slightly modified version of the first experiment:

“You have spent $100 on a ticket for a weekend ski trip to Michigan. Several weeks later you buy a $50 ticket for a weekend ski trip to Wisconsin.

You think you will enjoy the Wisconsin ski trip more than the Michigan ski trip. Suddenly you realized your just-purchased Wisconsin ski trip is the same weekend as the Michigan trip! It’s too late to sell either ticket, and you cannot return either one. You must use one ticket and not the other. Which ski trip will you go on?

$100 ski trip to Michigan OR $50 ski trip to Wisconsin?”

Think about it and write your answer down.

THE ANSWER SHOULD ALWAYS BE WISCONSIN!

It literally says, “you think you will enjoy the Wisconsin ski trip more”.  Forget the price or what you purchased. The Wisconsin trip is the better trip! Go on the better vacation! Why would any pick a worse vacation?

Of course, 54% of respondents picked the Michigan vacation, and only 46% picked Wisconsin.

People who pick the Michigan trip say it’s because they don’t want to “waste the money.” But that money is already gone. It was spent and is a sunk cost.

Obviously, a fascinating result. And there are other questions that are variations on this theme.

The other interesting result was an experiment researchers did at the Ohio University Theater. People who bought season tickets were put into one of three conditions. One group got the normal price, one got a $2 discount (on each $15 ticket), and the third got each ticket for $7.

Results? The no-discount group used significantly more tickets (4.11) than both the $2 discount group (3.32) and the $7 discount group (3.29); but only for the first half of the season. There was no significant difference in the second half.

Now there are potentially a few factors at play. The first is sunk cost. After purchasing a season pass, those that paid full price felt compelled to go and not “waste money”. Even though it’s a sunk cost. Those who paid less had a smaller sunk cost effect.

The second main factor that may be operating is that people who pay more may give the concert tickets a higher value. The higher value is because it’s “worth” more for those who bought at full price than those who bought at reduced price.

Either way, the fact that the effect was time limited and faded after a few months is another interesting twist. The study doesn’t present a causal link, but there are a number of behavioral economics effects that seem to fade over time.

The takeaway here is that the sadness of a sunk cost may fade over time, and eventually fades away to a point where it truly is sunk. Maybe it’s just people’s way of processing grief. I know this author would grieve a lost torta.

So again, your mileage may vary. The effect may be strongest at the moment of “sunk” (think torta on the ground). And then its magnitude (technically amplitude) fades over time as the person goes through acceptance.

What are some real world applications?

Use the fear of sunk costs to stop customers from switching. Try breaking a payment in half or into smaller payments, and make each payment final.  For example, tell the customer that they can’t complete the training without finishing the entire payment. This will trigger the fear of loss due to a sunk cost. The customers will want to pay to finish the training.

Conversely, if a customer feels like their payment has been wasted somehow, they will be much less likely re-up to get back to their starting position. This can generate a lot of negative emotions; even if it’s not even your fault.

For example, let’s say someone gets $800 of car work done and then the next week finds out that they need another $800 done on a different part of the car. They’ll be very hesitant to do so because of the sunk cost even though the two are unrelated. They should pay for both repairs, but the sunk cost and fear of loss will make them warry of spending more.

So that’s sunk costs. I hope you sunk some effort and energy into this topic! You’ll never get it back; it’s sunk.

On a personal note. This can apply to relationship and other personal feelings too. Letting go is hard. It’s a feeling of loss that we can’t get back. It really sucks. But this author’s personal advice is to take a deep breath and remind yourself that a sunk cost is gone. It’s just that; sunk and unsalvageable. You can’t get it back, and feeling bad about things doesn’t help anything. Use some mental scissors. Clip away the old circumstances and make your current situation the only factor that matters and make your decision from there. It’s the best way to move forward; even if it’s hard to do.

 

Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes35(1), 124-140. doi:10.1016/0749-5978(85)90049-4

Episode 9: What Are Heuristics?

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