In economics and business decision-making, sunk costs are retrospective (past) costs that have already been incurred

and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective and prospective costs may be either fixed (that is, they are not dependent on the volume of economic activity, however measured) or variable (dependent on volume). In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that an economic actor not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem. Evidence from behavioral economics suggests this theory fails to predict real-world behavior. Sunk costs greatly affect actors' decisions, because many humans are loss-averse and thus normally act irrationally when making economic decisions. Sunk costs should not affect the rational decision-maker's best choice. However, until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes. For example, if one is considering preordering movie tickets, but has not actually purchased them yet, the cost remains avoidable. If the price of the tickets rises to an amount that requires him to pay more than the value he places on them, he should figure the change in prospective cost into the decision-making and re-evaluate his decision.
Contents
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1 Description 2 Features characterizing the sunk cost heuristic

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2.1 Overly optimistic probability bias 2.2 Requisite of personal responsibility

3 Loss aversion and the sunk cost fallacy 4 Sunk cost dilemma 5 Bygones principle 6 See also 7 References 8 Further reading

[edit]Description This section does not cite any references or sources. Please help improve this section by adding citations to reliable sources. Unsourced material may be challenged and removed. (August 2007) The sunk cost is distinct from economic loss. For example, when a car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, then it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which is no longer relevant to decisions about the future; it may be used inconsistently in quantitative terms as the original cost or the expected economic loss. It may also be used as shorthand for an error in analysis due to the sunk cost fallacy, irrational decision-making or, most simply, as irrelevant data. Economists argue that sunk costs are not taken into account when making rational decisions. In the case of a movie ticket that has already been purchased, the ticket-buyer can choose between the following two end results if he realizes that he doesn't like the movie: 1. Having paid the price of the ticket and having suffered watching a movie that he does not want to see, or; 2. Having paid the price of the ticket and having used the time to do something more fun. In either case, the ticket-buyer has paid the price of the ticket so that part of the decision no longer affects the future. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the movie at all, regardless of the price, just as if he were to go to a free movie. The economist will suggest that, since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.

Sunk costs may cause cost overrun. In business, an example of sunk costs may be investment into a factory or research that now has a lower value or no value whatsoever. For example, $20 million has been spent on building a power plant; the value at present is zero because it is incomplete (and no sale or recovery is feasible). The plant can be completed for an additional $10 million, or abandoned and a different but equally valuable facility built for $5 million. It should be obvious that abandonment and construction of the alternative facility is the more rational decision, even though it represents a total loss of the original expenditurethe original sum invested is a sunk cost. If decision-makers are irrational or have the wrong incentives, the completion of the project may be chosen. For example, politicians or managers may have more incentive to avoid the appearance of a total loss. In practice, there is considerable ambiguity and uncertainty in such cases, and decisions may in retrospect appear irrational that were, at the time, reasonable to the economic actors involved and in the context of their own incentives.

Daniel Kahneman

Behavioral economics recognizes that sunk costs often affect economic decisions due to loss aversion: the price paid becomes a benchmark for the value, whereas the price paid should be irrelevant. This is considered irrational behavior (as rationality is defined by classical economics). Economic experiments have shown that the sunk cost fallacy and loss aversion are common; hence economic rationalityas assumed by much of economicsis limited. This has enormous implications for finance, economics, and securities markets in particular. Daniel Kahneman won the Nobel Prize in Economics in part for his extensive work in this area with his collaborator,Amos Tversky