RF Winter 04 FINAL.ps - 1/10/2005 13:56 PM

JARGONALERT Sunk BY ERIC NIELSEN

uppose the local theater is putting on a production go to the play or skip it. If you go, you will pay for the of your favorite play. In anticipation of the event, ticket and waste a few hours. If you do not go, you will still S you order tickets ahead of time for the second pay for the ticket and possibly spend the time doing some- performance. Unfortunately, your best friend sees the play thing more enjoyable or productive. No matter what you do, on opening night and tells you that it is awful and no one you pay for the ticket so it makes more sense not to go with any judgment would enjoy it. You now are in a bind and enjoy yourself instead. because the ticket you purchased is nonrefundable, and Though the above example may appear relatively harm- you really do not want to see the play. What should you do? less, the natural human tendency to consider sunk in Many people would go to see the play anyway, so as decisionmaking can have major policy implications. Just not to waste the they paid for the ticket. This is a like people, businesses and government are often loathe to very natural psychological reaction that economists call admit they made a mistake, cut their losses, and start anew. “.” People do not like to feel that they have This tendency to hold on to failing programs too long may spent for no reason. However, natural as it may be especially acute in the public sector since the be, basing decisions on irrevocable past incentive is muted or nonexistent. expenditures is a classic Ultimately, if a business refuses example of the “sunk to admit it has made a mistake, cost” fallacy. it will go out of business or Economically become significantly less com- speaking, a sunk cost petitive. Governments face little is an expense that has or no such to already been incurred perform efficiently. and cannot be recov- The United States is cur- ered. For example, the rently engaged in military theater ticket above is action in Iraq — and there are a sunk cost because it has strong arguments from many already been purchased sides on how we should and cannot be refunded or proceed. For example, some easily resold. have argued that we should with- Advertising expenses are draw carefully from the region another example of a sunk cost. Let’s say you invest now, while others maintain that we should stay until the $1 million promoting a new product but find out that area is fully stabilized. It’s not clear which side is correct. few people are interested in actually buying it. You could What is clear, though, is that U.S. policymakers should continue to pump money into hawking the good — not weigh only the benefits and costs of leaving at the present wanting to admit failure — or you could move on and moment. The time and money that have already been spent promote a different product. Either way, you won’t be are sunk costs and should not be considered. It might be able to recover that initial $1 million . It is a best for us to stay, but the fact that we are already there is sunk cost. not a reason for us to remain. To argue that we should Sunk costs are contrasted with incremental costs. An finish what we started — no matter the consequences — incremental cost is one that will change with a particular would be to fall prey to the sunk-cost fallacy. course of action. For example, when you are at the grocery Costs are everywhere in life. Indeed, teaches store deciding what and how much to buy, the decision to us that they are unavoidable. So it is natural and rational purchase an extra loaf of bread involves an incremental to consider the costs of an action before proceeding. But cost. The expense of the bread will be incurred only if we should be careful to focus on those costs we can affect you decide to buy it. at the present — and not on the sunk costs that we have A rational economic actor considers only incremental already incurred. Focusing on sunk costs is ultimately costs when making a decision. It makes no sense to factor counterproductive and can only be justified through our in sunk costs precisely because they are sunk; no present psychological prejudices. Still, the urge to do so is strong, action can change them. No matter what happens, the sunk and explains why the practice is common among both costs are always there. In the theater example, you can either consumers and policymakers. RF ILLUSTRATION: TIMOTHY COOK

6 Region Focus • Winter 2005