Microeconomic Life Lessons: Sunk Cost
Imagine: My friends and I are at an all-you-can-eat Japanese restaurant celebrating a tournament win. We are stuffed to capacity and cringe at the thought of putting another piece of food in our mouths. An uneaten roll taunts us from the table. The sushi can’t be wrapped up and taken home. We do what the average American would do -the ladies are spared as the big guys at the table eat themselves to near-sickness. Their argument for eating the last roll is that they would not get the full value of their initial payment if they didn’t. To my surprise – they finish the roll on the table and order a few more. Then dessert. Then someone throws up.
This episode occurred before I took my first economics course. An understanding of sunk cost may have helped our over-eaters make better decisions.
Wikipedia entry on sunk cost:
In economics and in business decision-making, sunk costs are costs that have been incurred and which cannot be recovered to any significant degree…Economics proposes that a rational actor does not let sunk costs influence one’s decisions, because doing so would not be assessing a decision exclusively on its own merits….For example, when one pre-orders a non-refundable movie ticket, the price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back the money he originally paid.
When we saw the roll on the dinner table we had two options:
1. Eat the roll – causing discomfort.
2. Let the roll go (and learn not to waste food in the future by ordering smaller portions).
No matter which option is chosen – we have already incurred the cost of the meal. Therefore, the information about the price we have already paid is irrelevant. A rational actor would choose the option that provides the greatest happiness (utility). In our case, leaving the roll on the table with a big tip and going home with a “I just ate sushi” glow on our faces, would have been a much better alternative to leaving an even bigger tip after a watching friend throw up in a restaurant.
I’ve been taught never to waste anything (especially food) – I’ve been known to use questionable bread for French Toast, pick brown pieces of lettuce off out of the bag, and prefer information from a “smell test” to to written expiration dates. My knowledge of sunk costs has helped me realize that I should buy less and order smaller portion sizes to avoid these situations altogether. Sunk costs should be barriers to entry – people should think about costs that cannot be recovered no matter what course of action is taken and factor that into their decision-making. In situations where I have to make the choice to suffer or let it go – I’ve learned to just let it go.
This concept can be applied to other situations:
– Choosing whether or not to go to a lame party after you’ve bought the non-refundable tickets and attire.
– Deciding to downgrade to Windows XP after buying Vista (I offer my sympathy to Windows users who have to make these tough decisions…).
– Exiting the Iraq War