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:
- 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?
- 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.
- 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.
- 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?