This article describes Sunk Cost Fallacy that explains why we often take irrational decision and why sometimes it is a good idea to forget the past.

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Definition

Sunk Cost Fallacy is the phenomenon whereby a person is reluctant to abandon a strategy or course of action because they have invested heavily in it, even when it is clear that abandonment would be more beneficial. It describes our tendency to follow through on an endeavor if we have already invested time, effort, or money into it, whether or not the current costs outweigh the benefits.

Examples

  • Individuals sometimes order too much food and then over-eat just to “get their money’s worth”.
  • A person may have a $20 ticket to a concert and then drive for hours through a blizzard, just because she feels that she has to attend due to having made the initial investment.
  • A business organization, after investing huge amount of time, money, and resources, doesn’t want to drop the buggy ERP system (that is being currently used) that is continuously causing managerial problems, and customer dissatisfaction problems by providing wrong information, and inaccurate reports.

The Underlying Psychology 🧠

Behavioral scientists and economists are constantly trying to understand the reasons why we make irrational decisions. Richard Thaler (1980), a pioneer of behavioral science, first introduced the sunk cost fallacy. Psychologists believe that the sunk cost fallacy occurs because we are not purely rational decision-makers and are often influenced by our emotions. When we have previously invested in a choice, we are likely to feel guilty or regretful if we do not follow through on that decision. There are two possible reasons that explain why a person might fall victim of sunk cost fallacy:

  1. Commitment bias
  2. Loss aversion principle

1. Commitment Bias

The sunk cost fallacy is associated with the commitment bias, where we continue to support our past decisions despite new evidence suggesting that it isn’t the best course of action. We fail to take into account that whatever time, effort or money that we have already expended will not be recovered. We end up making decisions based on past costs and instead of present and future costs and benefits, which are the only ones that rationally should make a difference.

2. Loss aversion principle

The sunk cost fallacy may in part occur due to loss aversion, which describes the fact that the impact of losses feels much worse to us than the impact of gains. We are more likely to avoid losses than seek out gains. We may feel that our past investment will be ‘lost’ if we don’t follow through on the decision, and make a decision based on loss aversion rather than consider the benefits that would be gained if we did not continue our commitment.

Final Words

The sunk cost fallacy is a vicious cycle because we continue to invest money, time and effort into endeavors that we have already invested in. The more we invest, the more we feel committed to continuing the endeavor, and the more resources we are likely to put in to follow through on our decision.

Reference

Thaler, R. (1980). Toward a positive theory of consumer choice. Journal of Economic Behavior & Organization1(1), 39-60. https://doi.org/10.1016/0167-2681(80)90051-7