Sunk cost
[3] In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future.
According to classical economics and standard microeconomic theory, only prospective (future) costs are relevant to a rational decision.
This formulation makes clear how central the principle is to standard economic theory by, for example, founding the folding-back algorithm for individual sequential decisions and game-theoretical concepts such as sub-game perfection.
For example, if a firm sinks $400 million on an enterprise software installation, that cost is "sunk" because it was a one-time expense and cannot be recovered once spent.
A "fixed" cost would be monthly payments made as part of a service contract or licensing deal with the company that set up the software.
There are cases in which taking sunk costs into account in decision-making, violating the bygones principle, is rational.
[14] For example, for a manager who wishes to be perceived as persevering in the face of adversity, or to avoid blame for earlier mistakes, it may be rational to persist with a project for personal reasons even if it is not the benefit of their company.
[16] People demonstrate "a greater tendency to continue an endeavor once an investment in money, effort, or time has been made".
[17][18] This is the sunk cost fallacy, and such behavior may be described as "throwing good money after bad",[19][14] while refusing to succumb to what may be described as "cutting one's losses".
Individuals caught up in psychologically manipulative scams will continue investing time, money and emotional energy into the project, despite doubts or suspicions that something is not right.
[21] Rego, Arantes, and Magalhães point out that the sunk cost effect exists in committed relationships.
According to evidence reported by De Bondt and Makhija (1988)[full citation needed], managers of many utility companies in the United States have been overly reluctant to terminate economically unviable nuclear plant projects.
From these reviews, De Bondt and Makhija find evidence that the commissions denied many utility companies even partial recovery of nuclear construction costs on the grounds that they had been mismanaging the nuclear construction projects in ways consistent with throwing good money after bad.
In practice, there is considerable ambiguity and uncertainty in such cases, and decisions may in retrospect appear irrational that were, at the time, reasonable to the economic actors involved and in the context of their incentives.
Some research has also noted circumstances where the sunk cost effect is reversed; that is, where individuals appear irrationally eager to write off earlier investments in order to take up a new endeavor.
[28] This is a hazard for ships' captains or aircraft pilots who may stick to a planned course even when it is leading to fatal disaster and they should abort instead.
A famous example is the Torrey Canyon oil spill in which a tanker ran aground when its captain persisted with a risky course rather than accepting a delay.
[33] It has been a factor in numerous air crashes and an analysis of 279 approach and landing accidents (ALAs) found that it was the fourth most common cause, occurring in 11% of cases.
The first is an overly optimistic estimate of probability of success, possibly to reduce cognitive dissonance having made a decision.
[36] Evidence from behavioral economics suggests that there are at least four specific psychological factors underlying the sunk cost effect: Taken together, these results suggest that the sunk cost effect may reflect non-standard measures of utility, which is ultimately subjective and unique to the individual.
Ellingsen, Johannesson, Möllerström and Munkammar[40] have categorised framing effects in a social and economic orientation into three broad classes of theories.
Their hypothesis was that people who had just committed themselves to a course of action (betting $2.00) would reduce post-decision dissonance by believing more strongly than ever that they had picked a winner.
Knox and Inkster performed an ancillary test on the patrons of the horses themselves and managed (after normalization) to repeat their finding almost identically.
In the low responsibility condition, subjects were told that a former manager had made a previous R&D investment in the underperforming division and were given the same profit data as the other group.
