Don’t Be Fooled By Sunken Costs

A few years ago I managed to nab a used Wenger Swiss Army watch off of eBay for $35. I really liked the watch since it was classic but not flashy (shown to the right) – and it didn’t hurt that it retailed for over $200! Recently it abruptly stopped working, and so I brought it in for a battery replacement. Unfortunately, it turned out the entire mechanism was burnt out and it would cost $50 to replace. Pay $50 to fix a $35 watch? Nah, I’d see what else was out there. I was actually considering buying a similar watch from Costco for $150 before I caught myself. I was being fooled by the sunken-cost fallacy!

What Are Sunken Costs?
A sunk or sunken cost is something that has been spent and cannot be recovered. Since this is the case, economists argue that such sunk costs should not be a factor in one’s decision making. The classic example is the movie ticket decision (adapted from this Wikipedia entry).

Let’s say you bought a non-refundable movie ticket, but you later decide that you no longer want to watch the movie. Do you watch the movie anyway since you already paid for it, even though you won’t enjoy it? Or do you simply walk away and do something better with your time? Since the ticket was a sunken cost, a rational decision maker would ignore the fact that you paid for it already. In fact, you should act as if the movie was free.

A few more examples:

  1. Clothes. You bought a pair of $100 shoes, but after wearing them around you find that they hurt your feet horribly. Do you continue to wear them anyway?
  2. Consumer Products. Sometimes companies will continue to plow money into a project even though they know it will be a failure, simply because millions have already been spent on it. It’s important to know when to cut your losses. A historical example is the Concorde jet.
  3. Investing. Many people hate selling their shares for less than they paid for it. However, once you’ve executed the trade, that shouldn’t matter anymore. All that should matter are the current prospects for the stock.
  4. Human lives. This idea has even been extended to the Vietnam War and more recently the Iraq War, when the loss of previous lives has been used as justification for continued fighting.

But back to my watch story. I realized that it shouldn’t matter what I paid for the watch. The fact was that I could still get a working watch for $50, while replacing it would cost me significantly more. Nothing similar was selling for less than $100 on eBay, and a new one would cost at least $200. I went ahead and told the jeweler to fix my watch for $50.

Have you caught yourself worrying about sunken costs as well? You can also read about other ways that our mind plays tricks on us in Mental Accounting: Is A Dollar Always A Dollar?

Comments

  1. RealBusiness says:

    I have bought lots of time a t-shirt or a shirt and maybe wear it once than hide it in the closet :)

  2. Drew Miller says:

    Your situation doesn’t really seem like an example of a sunk cost fallacy – almost the opposite, in fact. You felt that because you got your watch for so little, you shouldn’t spend more money on it. The sunk cost fallacy is where you’ve spent so much on something, you feel like you need to keep spending money on it.

  3. Are you sure the jeweler is being honest and the watch really is broken?

  4. Plan C: throw the watch out and buy a timex.
    Plan D: pay 50 to fix it. Sell on ebay. Use profits to buy a timex.

    -Wes

  5. Looks like John McCain has fallen for this re: the Iraq war as well.

  6. I really hope this blog doesn’t go political. I’ve stopped reading other blogs b/c the authors/commenters couldn’t help themselves to interject some commentary about the political landscape even though the blog had nothing to do with politics.

  7. so please advise me on this one then –

    We bought a pretty good vacuum about 5 years ago for about $300.00. Well it stopped working — I think it was only the power cord connection, but I couldn’t easily take it apart. I brought it in for repair and they want $129.00 to fix it. I think I should just get a new vacuum — the vacuum may last another 5 years, but it’s not as good as new one.

    I have more of an issue however, with my home. We re-did the place from the studs and that’s the real reason I want to keep it as a rental. I’d never get back the money in renovations (new heating sytem, new electrical system, new electrical box, new sheetrock, kitchen, etc., etc.). So I figure it will be a great investment property because nothing major should break for many years, yet I don’t really want to be a landlord. I just know we went through a lot of aggravation and money with this house and I want some payback — so your “sunk cost” really hits home with me.

  8. “So I figure it will be a great investment property because nothing major should break for many years, yet I don’t really want to be a landlord.”

    If it bothers you because of having to deal with the tenants and the financial aspect of renting property isn’t your concern, you may want to consider hiring a property manager. Keep in mind that you’ll be paying a percentage of the rent to the PM though.

  9. For me, the pleasure/pain factor is a very real factor in my decisions. I value my pleasure (and lack of pain) very much, even though it may be hard to put a dollar amount on it. Therefore I tend to take each situation as it arises.

    If I pay for a movie and I really dislike it, I will walk out because my pleasure (not to mention my time) is worth more than the $7.50 ticket. Similarly, if I had a watch that I really liked, then I’d weight the amount of pleasure that I receive from the watch against the pleasure and pain of replacing it.

  10. We already talk about one potentially inflammatory subject (money) do we have to through politics in there too? Why not start with religion while you are at it.

  11. Ted Valentine says:

    Where is the political comment by Jonathan? I see one from a commenter. I don’t see Jonathan make a statement either way. He’s using an example. I really don’t see how a $50 sunk cost can be compared to human lives, so maybe its not the best example. Still, some of you need to lighten up.

  12. To see one sentence which applies economic reasoning to the ethics of warfare and subsequently bemoan that the blog has “gone political” is overly sensitive, and in fact, political on your part of the accuser (far more so than the post itself). The “human lives” example was (1) fair, (2) non-judgmental (value-free), (3) not radical, and (4) 100% relevant to the financial topic of sunk costs. Economic reasoning applies to all human activity, and the “human lives” example was one way of demonstrating the principle.

    Sunk costs can apply to gift cards. Say you buy a $50 gift card to Barnes and Noble. You later decide you don’t want to buy anything from them, and decide to sell the card. So you get on eBay and are shocked to see $50 gift cards going for $45 — a “loss” of five dollars!

    But the $50 you spent on the card is a sunk cost. It is no longer relevant. The question is not how much greater the resale price is compared to the original purchase price. Instead, the goal should be to get the most value out of the asset which you already own. You have two options: use the card for goods, or sell the card for cash. Using the gift card on stuff you don’t want is not going to give you much utility. The $45, although less than the $50 purchase price, will give you more utility.

    Also, sunk costs are highly applicable to poker games. Often, a player will keep matching another player’s raised bid. The first player may sometimes believe that to fold his hand after “going in” so far, would be to waste the $200 worth of chips he’s thrown into the pot up to that point. Not true. He can’t get the chips back once they’ve been bid. The only chips he controls are the ones he hasn’t spent yet. So when the second player raises the bid by $10, the first player must ask himself, is my hand powerful enough to beat my opponent’s? Is it worth spending $10 to purchase a chance to win the pot?

  13. The concept you bring up here is a very very good one, and one I find myself forgetting all the time.

    I think a buffet is a good example for your list. People get an all you can eat buffet meal and think that they must stuff themselves to get the most out of the meal. And usually at some point during the meal you realize that it would have been cheaper to just get the dish(es) you want and then you even get left overs for the next day.

  14. Sorry, didn’t mean to upset people. I should have had a more substantive response, rather than a one-liner which could have been interpreted as a political flame. So, I will clarify…

    Jonathan’s article that he linked talks about Pres. Bush using the comment “We will finish the task that they gave their lives for” to support the continued war effort. I have heard this comment many times (i.e. “we will not let our soldiers die in vain”) not just in this example, but for wars throughout history (and for many countries, not just the U.S.). The line is even popularized in Hollywood-made war movies. My comment was related to Senator McCain, as he has made the same statement while on the campaign trail, which indicated that it was not just Pres. Bush who has made this remark, and this is what I thought Jon might be asserting based on the article that he linked. So there are many public figures who fall into the sunk cost fallacy. I am sure that many others have made it as well. But just because politicians are involved doesn’t mean it isn’t relevant to the discussion.

    What I find most amazing is that, with regards to the linked article, it is clearly an argument based on a sunk cost, which as we know from economics and business classes should have absolutely zero factor in future decision making, and yet it does and continues to do so. It would seem that it is an emotional justification, rather than a logical one. And whether related to war or movie tickets, people seem to have a need to “justify” past purchases instead of looking to the future, which is clearly irrational.

  15. I think sunk costs is a fundamental unconscious issue behind compulsive hoarding. To use your shoe example, how many times does someone think “These hurt my feet *now*, but might fit me *later*?” Think of how much storage space/extra house space people buy to accomodate the desire to avoid making hard choices around the question “how much stuff am I willing to keep on hand?”

    I know I have “portfolio proliferation” with regard to this too…it’s really hard to get ruthless and get rid of all the financial clutter (obsolete life insurance policies, mutual funds that are so-so, automatic payments to a service I don’t use anymore) so that you have something with a truly aligned, effective purpose at the very end.

  16. All in all, I think you’re making a good point… however, I do think it can do some good to give your self a little (just a little) mental anguish over the potentially unrealistic decision you made when you, for instance, bought that non-refundable movie ticket you didn’t use. Although it makes no sense to see the movie even if you don’t want to see it, it does make some sense to reflect on the situation so that next time you might not buy a non-refundable ticket you can’t use. Maybe a non-refundable ticket with an expiration date really isn’t such a good deal. I don’t think you can just forget about bad decisions, but knowing how to take a loss is certainly a valuable skill.

  17. Excellent article about sunk cost fallacy, but I agree with Drew that I don’t think your scenario is an example of sunk cost fallacy. A sunk cost scenario would be more like this: You bought a new watch for $200 and it broke, which costs $50 to fix. Or you could buy a similar used one for $35. But you reason that you already spent $200 for your watch, if you bought another used one for $35, it’d be a waste of the $200. So you opt to fix it for $50.

  18. The word sunk costs brings my mind back about 4 years ago in economic class. Boy those were some interesting classes.

    The point in this post though is to remember whether future additional benefits outweight future additional costs and that past costs should not bear any weight into your decision.

    I have to remind myself this every day as my 1992 Honda Accord slowly falls apart. But having no car payment in exchange for periodic repairs that are less than monthly car payments is why I continue to drive it.

  19. While I no longer wear a watch, I had been buying the cheap watches at places like Target or Kohls. On quite a few occasions I have received comments about how nice my watch was and once had someone with a $500+ watch ask me if I had the same watch. When I told him that my watch cost $15 at Target he didn’t feel so great about his expensive watch, lol.

  20. I am so guilty of the sunken cost trap. I really need to be more aware of this concept. Thank you very much.

  21. A good book on knowing when to stick and when to bail is called “The Dip” by Seth Godin. It’s talking more about working on a project, but the logic is the same – invest more of your time and/or money, or when to cut your losses and move on.

  22. When doing online research about sunken costs, examples using the Vietnam war because of specific information about Lyndon B Johnson were actually some of the top results. It’s actually in the Corncorde Jet link. If you read the Slate article, the author is not against the war per se, but calling out one specific reason being put out for the war.

    I’m probably one of the least political people you’ll ever meet, for better or worse. Read through my last 3.5 years of blog posts and you’ll see that :) Anyhow, I knew I was playing with fire there but I still think it’s a interesting example and I thought it was appropriate and educational to point it out.

    Yeah, I know my watch example isn’t perfect, but it’s kind of a reverse sunk cost. But the point is that you shouldn’t look back at money already spent which can’t be refunded.

  23. mimi = Both your situations are tough. Many sunk cost examples have many shades of grey. Like it or not, emotion plays a role in our decision-making, it’s just important to identify them.

    Regarding your house, let’s say you inherited it from a long-lost uncle. However, you know that everything in it is new and the craftsmanship is excellent. Would you still sell it or rent it out? How is the cashflow scenario? You could also try renting it out for a while and see what happens.

  24. It is very smart of you to fix your watch. First of all the buy a new one when it’s broken mentality is an american disease. The rest of the world over actually fixes things that are broken which 1. forces manufactures to make better quality items and 2. is better for the environment. Items like watches are meant to be had for a loooong time that is why you generally pay good money for them. I am very much of the buy the best within you budget take care of it and have it for ages mentality. In fact my watch is 35 years old and was handed down by my grandmother. It is worth the occasional $ to fix it.

  25. Now wait a minute. Who said the entire concept of “sunken costs” is “correct”? I mean, think about it, it actually uses an artificial predisposition (that there’s only one CORRECT way to make ‘rational/logical’ decisions) to invalidate the actions it’s trying to proof to be “WRONG”. It’s very much like some religions trying to disproof some human behaviors using their own religious dogma as the only truth where in actuality, their own dogma could very much be false in the eye of other religions.

    The truth of the matter is that in social science arena, especially economics, no theory is more relative. Especially when you keep making the mental calculation that what you decide might make you come up ahead of others (economically). This mental calculation is by no means to be “correct” or “false” one way or another.

    It’s very possible that you followed every single principle that these economic theories that taught you but you still end up not that much ahead (thinking all the economic professors, how many of them are multi-millionaires?). And it’s also entirely possible that the true “winners” of the society took some very “incorrect” and “risky” turns but against all odds (especially all those odds in the economic theories), they pulled ahead big time.

    go figure.

  26. It’s like cars that are “totaled” simply because it costs more to fix than the vehicle is worth. It would make more sense to pay a few thousand for the cost to repair the vehicle than to spend 10′s of thousands on a new vehicle or used vehicle but of course insurance companies don’t see it that way because it doesn’t make sense for them to give you more money than they feel they have to.

  27. Narcissus Black says:

    Nutshell: Sunk cost = cost of entry or barrier to entry. Once it’s spent, you might as well let it go. If you want an omelette you have to break some eggs. Breaking the eggs is the first hurdle that has to be overcome in getting breakfast in your belly… and one that can not be avoided should one want to eat them any way other than swallowing them whole – snake-style. I think a more meaningful study of the watch scenario might be found in opportunity cost.

  28. I don’t know, Arz, but I’d say that these economists have a pretty good start: http://nobelprize.org/nobel_pr.....laureates/ I personally think the better question is how many economics professors follow the economic theories? Don’t forget that economics professors are merely a subset of all economists. How many finance professors are multi-millionares?

    Furthermore, those that do make it big by doing “risky” things aren’t necessarily ignoring the economic principles: “risky” all depends on one’s risk adversity–any econ major that stayed awake for intermediate micro could tell you that one. Decisions that have uncertainty and a probability of return have different thresholds of acceptable returns depending on how risk adverse a person is. Look into expected utility and the certainty equivalent of a gamble for more information on that.

    You are entirely right that calling the sunk cost fallacy correct is subjective–correct all depends on how your assumptions measure utility on emotional attachment. (The sunk cost theory puts no utility on emotional attachment or considerations.) Utility, of course, is the ULTIMATE in subjective, though. ;-)

  29. please, please, please don’t play with political fire my brotha

  30. the rapid pace of technological development has certainly changed ideas about sunk costs as Mimi discusses in her vacuum dilemma. Vacuums seem to be a great example of the salesman coming in, selling a very expensive durable good that turns out to be not so durable.

    When attempting to find an optimal repair, difficulties arise in finding a quality place to repair the expensive good at a reasonable price. On one hand, there is no guarantee that the repair will last as long as a new vacuum – unless there is a guarantee. Finding cheap electronics repairs can be impossible. $35 to touch(fix) a DVD player = cost of new cheapo DVD player.

    Vacuums are not the perfect example of rapid tech development though. I’m thinking of TVs, computers, monitors, stereo and DVDs. Chances are, if you got 2 years out of a computer and it dies, it may be time for a new one. The new technology will be twice as good and half as much as the original item. so…now you must balance the costs and benefits of new and improved vs. cheaper fix, but sacrifice in quality. (Here Jon’s example breaks down as watches don’t have obvious technical improvements in the short term.) The original item, with the sunk costs is now inferior to competitive market goods.

  31. Alex Coward says:

    Lose the watch. What do you need it for?
    Walk around without a watch for a couple months and see if you really miss it in that time.

  32. To say the least, if Jonathan pays $50 to repair the watch, and then sells it on eBay, how much can get get it out of? Then there’s a look and feel of that watch that may or may not be valued in terms of dollar amount. Then there’s a practical thing there that he needs another time piece anyhow. Is spending another $150 to get a new watch a wise thing to do?

  33. Tom Miller says:

    I agree with Derek on this one. I have not worn a watch for many years, and don’t miss it. I carry a cell phone which has a clock on it, and is more acurate than a standard wrist watch.

    I think you made a wise choice getting the watch fixed. The $50 cost to get it fixed seems high compared to the price paid, but still cheaper than replacing the watch. Just think of it as paying $85 bucks for the watch, which is still cheaper than a replacement on ebay!

  34. As others have said, the danger of applying sunk cost theory to financial life is that you start applying it before you’ve actually sunk the cost. In other words, I think a bit of squirming when you remember how much the coat you never wear that you’re taking to the charity store actually cost you is a *good* thing, as it may stop you buying another piece of shocking couture in the future!

  35. The idea of “planned or built-in obsolescence” does not help with the mindset for the idea of “sunken cost.” Which is having/going to have terrible effects on the environment. Think about how many huge rear-projection screen TVs were sold in the past dozen or so years. I had a 54″ Sony that just died. It would have been $350 for parts and another $200 for the service call and labor (minimum). I went and purchased a new HDTV for a few hundred dollars more. Why would I invest that money in a dinosaur that is outdated technology. So off to landfill with it, to join the hundreds of thousands of other like it.

    Computers as well. Who spends money on upgrades when new models are always available, at a reduced cost every quarter or so. Cellphones as well – new batteries are almost as much as a new phone – and most carriers give you a new phone free every two years or so. The idea of a product becoming obsolete and/or non-functional after a certain period or amount of use, approximately, as planned or designed by the manufacturer is rampant. Especially in technology. The rational is great for the manufacturer but terrible for the consumer and a plague on the resources that go into the product; not to mention the environment as a whole.

    A watch is different can of worms. Time is a function that does not change; time may march, but the concept remains the same. The government has not mandated a ‘New High Definition Chronology’ nor has Microsoft come out with Hourglass 5.6 to compete with the new Mac iTime.

    But with so much of our lives surrounded by technology and governed by its “advances,” I do not think that there are many people that are going to be jumping on the bandwagon to ‘fix’ their older pieces of technology.

  36. toasty aroma says:

    great analogy of sunken cost fallacy and the Iraq war. We are now simply trying to “save face” over there, and we have the “we broke it now we have to fix it” mentality. Spending 1.4 billion dollars a day to rebuild Iraq is the epitome of the sunken cost fallacy.

  37. I wouldn’t want someone to get carried away with this and justify every bad purchase they make, but the concept is correct. I bought tickets to a college football game that I thought my team was going to. They cost about $150 for a pair. Then my team wound up making it to a different bowl game. Someone offered me tickets to the game we were in, but part of me felt like i needed to go to the game that i sepnt money one. it was a sunk cost and i decided to go to the good game.

  38. Mimi: I’d never get back the money in renovations (new heating sytem, new electrical system, new electrical box, new sheetrock, kitchen, etc., etc.)

    Then why did you redo the place?

    There are two things going on here:
    1. You put $X into a place and those dollars will only increase the home value by a number less than X. That’s a hobby, not an investment.
    2. You may be confusing “renovations” vs. “maintenance”.

    You can fool yourself by saying nothing major should break for many years, but then, everything’s going to break all at once! Are you going to have the money to fix it all when that happens? Your house is both an investment and a depreciating asset.

    If you dropped $1000 on a new water heater with a 10 year warranty, then you’ll need $1000 inflation-adjusted in the bank account about 121 months from now to fight that depreciation.

    It’s the same thing with cars. People say “ah, nothing will break for a while, I’m good”. Then, when the tires go, or the belts need to be changed, or the transmission fails, they act all distraught. “Where am I going to find $600? ($1000, $2000)?” As if these things weren’t going to fail eventually. They tried to leverage all of the months where the car was working instead of putting money aside every month for the inevitable car expenses.

    I’m sure that you learned a lot of useful things while working on the house, but don’t imagine that you’re suddenly “scot-free” for the next 10 years. The stuff in your house is depreciating slowly, day-by-day, just the like the tires on your car are wearing every time that you drive on them. You can’t view future house repairs as “optional”, they’re “inevitable”, so you might as well start saving now.

    And the concept scales, we live in a “warranty-free” world, where technology-based products are constantly being cycled. When we’re buying big ticket items, we have to look at them as carrying an annual fee (cost over warranty). I bought my vacuum from Sears with the warranty factored in. It’s costing me $80/year to own a vacuum cleaner ($400 over 5 years). If you buy a computer from Dell with the 3-year warranty for $1500 you now have an annual computer cost of $500.

    It’s a long-term way of thinking that we typically don’t apply (unless you like cast-iron pans :), but in the age of high product churn, we’re going to have to learn to think differently.

  39. Well, for anyone interested – my vacuum dilemma ended on a happy note. We ended up calling the repair center and told them to forget the repair and we would just pick it up. I went to get it and expected to the $29.95 evaluation fee, but when I got there — the salesman told me the vacuum was already fixed. I thought I would end up paying for it anyway (not the end of the world), but he called over the manager and they told me I could just take it (!!). I almost felt bad taking it – but I did and thanked them.

    And as it happens they are selling some really nice discounted HDTVs, which I’ll probably go back for on Friday. I gotta keep them in business!

    As far as the house goes — you are right, Gates, it was my husbands’ hobby. Some of what we did definitely increased the value. But it’s funny, stuff like new wiring, insulation, no one pays for that. But for a landlord, those things are great. So I’m trying to get back the money that way. We may try it and see how it goes. What I’d really like to do is wait out this market a couple more years; buy another house in a better school district (my big mistake), and then just move and rent. But if renting is a bother, I may have to count this stuff as “sunk” and learn to live with it.

  40. My girlfriend and I got into an argument about this over concert tickets she had bought for about $25 each. When the night of the concert came, neither of us really wanted to go. I told her that we shouldn’t go, but she didn’t want to have wasted the $50. I tried to explain that the money was already spent and shouldn’t matter in our decision, but she kept insisting that “$50 does matter!” I emailed her a link to this article; hopefully she won’t relive how mad she was getting at me for calling her decision “irrational”! Also hopefully she won’t read all the way down to this comment!

    We ended up going to the concert but left early, not even waiting for the main band we wanted to see.

  41. Your girlfriend being irrational and you calling her irrational are two separate things :D Just kidding, hope everything works out well for you today on Valentine’s day!

  42. I think that this is a really interested post. I have not seen anything like it before. I think that addressing the issue of sunken costs is very important but no one really does it.

    In speaking about you movie example I would not go just because I spent the money if I had something productive to do instead.

    I buy stuff all the time and then never use it, this isn’t an issue with me but I see it as an issue with people all the time.

Trackbacks

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