What’s Really Going on With “Sunk Cost”

“Sunk cost” is tricky stuff.

It is a standard accounting term, referring to the investment already made in an asset or project. When deciding how to value the asset currently, or whether to invest further in the project, we are firmly admonished to ignore “sunk cost”, and to make our evaluations based on its current market value (or expected future value). This is sound advice, rational to the core, and is perfectly in accord with classic economic theory.

So what’s the rub? To the consternation of accountants, economists and financial advisors everywhere, when we look at actual investment decisions, people routinely do NOT ignore sunk costs. What they have already invested is typically a factor – sometimes a determining factor – in what they decide to invest now. Talk about “irrational”! And since behavioral economists do talk about “irrational” they account for this and many other common deviations from rational practice by invoking the “Endowment Effect.”

In the first post of this series, “Take the Cash and Let the Credit Go”, we saw how “loss aversion” is an ad-hoc account of research data that merely labels the phenomenon but in no way explains it, and gave an alternative formulation that actually predicts the research findings. In this post we will subject the “Endowment Effect” to the same treatment, with an interesting twist: exactly the same conceptual structure that predicts loss aversion also predicts the Endowment Effect! This is our first solid clue that we are on to something really different and powerful here. (And there’s a good deal more where these come from, as we shall see as this series unfolds.)

Incentives?

Economists talking about “incentives” remind me of a scene from the classic film “Cool Hand Luke.” Luke (Paul Newman), a prisoner on a southern chain-gang, stands up to the corrupt prison authorities. For his efforts he is badly beaten by the guards and thrown into a ditch. From the top of the levee the Captain (Strother Martin) looks out at the chain gang and proclaims this immortal line: “What we’ve got here, is a failure to communicate.”

Well, OK. You could put it that way. But in doing so you are entirely distorting the reality of what is going on (and of course that was the Captain’s intention.) Unfortunately economists seem unaware of just how badly their talk about “incentives” distorts the realities they are talking about.

Dan Ariely: An Appreciation

I have launched a series here on behavioral economics that makes sense of some material in Dan Ariely’s two bestselling books on behavioral economics: Predictably Irrational, and The Upside of Irrationality. In these posts I have some pretty critical things to say about this work, so I want to be clear from the start:

The critique is of the work, not the man.

Pay Attention to the Man Behind the Curtain

Research in behavioral science is hard.

Self-report is notoriously unreliable; rigorous observation of actual behavior is very difficult to get right; creating comparable experimental and control groups takes more than a little ingenuity – and then you have the problem of replicable results.  Researchers who find methods that even partially steer around these known difficulties become heroes in their fields; their methods become standards, and genuine scientific knowledge can result.

But sometimes this ingenuity results in denying the obvious, and then we get silly science leading to bad theory. Some behavioral economics experiments, alas, fall into that category. They embody the Wizard of Oz fallacy: insisting that experimental subjects “Pay no attention to the man behind the curtain” when the curtain is standing open for all to see.