Behavioral Economics : The Sunk Cost Fallacy and its Effect on Financial Decision Making

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• The Basics

The sunk cost fallacy is a phenomenon in which individuals continue to invest resources into a project or activity based solely on the fact that they have already invested a significant amount of resources, even when it is no longer rational to do so. In other words, people persist with an investment or activity because of past sunk costs, even though the costs cannot be recovered and the investment has no prospect of generating any returns.

Behavioral economists believe that the sunk cost fallacy is an example of irrational decision-making, driven by psychological biases such as loss aversion, which makes people reluctant to give up on something that they have already invested in. The sunk cost fallacy can occur in many areas of life, including personal finances, business, and politics.

For example, suppose a business owner invests a significant amount of time and money into a new product line that is not performing well. The sunk cost fallacy might lead them to continue investing in the product line, hoping that it will eventually generate a return on their investment. However, if the product line continues to underperform, the rational decision would be to cut losses and invest resources into a more promising area of the business.

Likewise, the sunk cost fallacy can apply to personal finances, where individuals may persist with an investment that is not performing well, such as a stock, bond, or real estate investment. Even though the investment is unlikely to generate any returns, the investor may feel reluctant to sell because they have already invested a significant amount of money.

• The Concorde Project

The Concorde project is a classic example of the sunk cost fallacy in action. The project was a joint venture between the British and French governments to develop a supersonic passenger aircraft that would revolutionize air travel by significantly reducing flight times. The project was launched in the 1960s and took over a decade to develop.

During the development of the Concorde, technical problems and escalating costs quickly became apparent. The original estimate for the development costs was £150 million, but this quickly ballooned to £1.3 billion by the time the first aircraft was delivered. Additionally, several technical challenges had to be overcome, including the design of the aircraft's engines and the development of the materials needed to withstand the high temperatures generated by supersonic flight.

Despite these challenges, the British and French governments persisted with the project, in part due to the sunk costs that had already been invested. Both governments had invested significant amounts of money and resources into the project, and they were reluctant to abandon it, fearing that it would be a waste of resources.

As a result, the development of the Concorde was characterized by numerous delays and setbacks, and the first commercial flight did not take place until 1976, over a decade after the project was launched. Furthermore, the cost of the project continued to rise, and it was ultimately estimated that the project cost over £3 billion to develop.

Additionally, the Concorde's commercial success was limited, with only 14 aircraft ever being built and only two airlines, British Airways and Air France, ever operating the aircraft. The Concorde was also subject to several accidents and incidents during its operational lifespan, which further tarnished its reputation.

In summary, the Concorde project is a classic example of the sunk cost fallacy in action. Both the British and French governments persisted with the project despite technical problems, escalating costs, and limited commercial success, driven in part by the sunk costs that had already been invested. Ultimately, the Concorde project was a commercial failure, and both governments lost billions of dollars due to their reluctance to abandon the project.

• Two Approaches to Avoid the Sunk Cost Fallacy

To avoid falling into the sunk cost fallacy, it is important to consider the costs and benefits of a project or investment independently of past investments. One approach is to consider whether the investment is likely to generate a positive return in the future, and to cut losses if it is not. Another approach is to use decision-making frameworks that explicitly account for sunk costs, such as cost-benefit analysis or option analysis.

• Conclusion

The sunk cost fallacy is a common example of irrational decision-making in behavioral economics, where individuals continue to invest in a project or activity based on past sunk costs rather than considering future costs and benefits. To avoid the sunk cost fallacy, it is important to consider decisions based on future costs and benefits, and not to let past investments cloud judgment.

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