Owen abstract an enlarged conceptual framework for understanding sunk costs and their implications is proposed. Today well explain what sunk costs are so you can avoid them. Download free engineering economics cost analysis notes notes and examples during class. Motivation and emotionbook2019sunk cost fallacy motivation. Jan 25, 2017 sunk cost for the project is the sum total of equipment sunk cost, cost of equipment that cannot be salvaged and the cost of labor. A potentially very effective way to teach people to ignore sunk costs is through examples in which people did not ignore sunk costs much to societys, or their own, ultimate detriment. Sunk costs, news and economic methodology by robert f. A sunk cost is a cost that has already been incurred and thus cannot be recovered. In economics and business decisionmaking, a sunk cost also known as retrospective cost is a cost that has already been incurred and cannot be recovered.
Once spent, the sunk cost cannot be recovered when the firm leaves the industry. Sunk costs in decision analysis in managerial economics. We study some important concepts of costs, and traditional and modern theories of. Endogenous sunk cost, quality competition and welfare. Sunk cost bias past losses matter when deciding whether to commit to one more heave. The cost of workers rises with the level of output. A sunk cost is always a fixed cost because it cannot be changed or altered. Sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered.
Sunk costs are past opportunity costs that are partially as salvage, if any or totally. Capital inputs that are specific to an industry and which have little or no resale value. The latter capture the interrelation between economic. The following are the various cost conceptstypes of costs. The psychology of sunk cost article pdf available in organizational behavior and human decision processes 351. Lets say a construction company has begun development of a new housing subdivision. The actual costs or expenditures are recorded in the books of accounts of a business unit.
School of systems and enterprises syllabus for em 600b engineering economics and cost. Sunk costs cannot be recovered if a business decides to leave an industry. They are therefore irrelevant to the decision at hand. In a certain sense, some sunk costs begin as variable costs. On the other hand, for cost concepts used for economic analysis of business activities, the costs included are fixed costs, variable costs, total costs, average costs, marginal costs, shortrun costs, longrun costs, incremental costs, sunk costs, historical costs, replacement costs, private costs, and social costs. Economics will help you get what you want out of life. Sunk cost as a selfmanagement device 4 managementscience,articles in advance,pp. I believe dawkins and carlisle 1976 were the first to use concorde as an example of the sunkcost fallacy, though they did not mention it by name a government which has invested heavily in, for example, a supersonic airliner, is. Business jargons economics book cost book cost definition.
The book cost refers to those expenses which do not involve actual cash payments, but rather the provisions are made in the books of accounts to include them in the profit and loss accounts and avail the tax advantages. The sunkcost fallacy pursuing an inferior alternative merely because we have previously invested significant, but nonrecoverable, resources in it represents a striking violation of rational decision making. If so, the opportunity cost of studying economics is enormous. Right now, the canadian government has paid an enormous amount of money for a payroll program that doesnt work.
A sunk cost differs from future costs that a business may face, such as decisions about inventory. Economics notes opportunity cost stephen palmer, james raftery the concept of opportunity cost is fundamental to the economists view of costs. Sunk cost is also known as past cost, embedded cost, prior year cost, stranded cost, sunk capital, or retrospective cost. There are several costs that a firm should consider under relevant circumstances. All ideas are contestable, so that comments are most welcome. Sunk cost why you should ignore them the sunk cost fallacy. Therefore, an individual should ignore sunk costs to make a rational choice. On the night of the concert, you remember that you have an important assignment due on the same night. I believe dawkins and carlisle 1976 were the first to use concorde as an example of the sunk cost fallacy, though they did not mention it by name. In economics and business textbooks, the tendency to honor sunk costs is treated as an elementary fallacy. Finally, where not clearly specified otherwise, all the examples, graphs and tables. Define the meaning of economics discuss the concept of business economics identify the differences between economics and business economics describe microeconomics and macroeconomics explain the laws of economics discuss economic static and dynamics.
Principles of managerial economics open textbooks for. A sunk cost is incurred in the past and cannot be changed. Sunk costs and market structure bridges the gap between the new generation of game theoretic models that has dominated the industrial organization literature over the past ten years and the traditional empirical agenda of the subject as embodied in the structureconductperformance paradigm developed by joe s. These costs wont affect the decision making and economic analysis at present and in the future. Interestingly, the sunk cost effect works in the opposite. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Perhaps at least, a small part of, a through z key words. Once a variable cost is incurred and cannot be recovered, however, it is necessarily. Fixing it will cost more than buying a payroll program that works from another software developer. The study concludes that the widget will not be profitable. Sunk costs and real options in antitrust analysis mit. On the other hand, for cost concepts used for economic analysis of business activities, the costs included are fixed costs, variable costs, total costs, average costs.
A sunk cost, also known as a stranded cost, is an expense that has already occurred and cant be changed or avoided. Organization of the book l1 part i basic notions of cost benefit analysis 1 chapter one the context of project analysis 15 chapter two identifying relevant costs and benefits 19 transfer payments 19 contingencies 20 sunk costs 21 externalities and linkages 21 multiplier effects 23 international effects 23. For example, a business may have invested a million dollars into new hardware. Cardinal analysis, ordinal analysis, production function, economies of scale, cost concepts, price determination.
Its obvious that a firms total revenue must exceed total costs if it wants to make a profit. An everyday example of a sunk cost is a no changes permitted. Different types of costs with examples from m to w. It is quite essential for a firm to understand the difference between various cost concepts for the purpose of productionbusiness decision making. But in this section, youll see why its helpful for firms to break down their costs to examine various types of costsfixed cost, marginal cost, average total cost, average variable costs, and. Arkes and blumer used the example of an aircraft project. The sunk cost fallacy is covered in any economics textbook. Sunk costs, opportunity costs and breakeven analysis. Pdf on apr 1, 2010, geoff covey and others published sunk costs find, read and cite all the research you need on. Here are two hypothetical examples that many people have experienced. In their 1985 paper the psychology of sunk cost, arkes and blumer use a number of experimental examples where they gave participants various pairs of questions to answer.
This book presents economic concepts and principles from the perspective of managerial economics, which is a subfield of economics that places special emphasis on the choice aspect in the second definition. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. A fixed cost, however, is not a sunk cost, because it can be stopped, for example, in the sale or return of an asset. The interpersonal sunkcost effect marginal revolution. In some cases quality competition may raise the fixed and sunk costs of a firms participation in an industry and, in turn, increase equilibrium industry concentration. In economics, a sunk cost is any past cost that has already been paid and cannot be recovered. Introductory textbooks in economics present this as. Sunk costs are irrecoverable whatever option is chosen. Once a variable cost is incurred and cannot be recovered, however, it is necessarily fixed in sunk terms. A nonsunk cost is a cost that will only occur if a particular decision is made. The title of this book comes from a quote by nobel prizewinning author george bernard shaw.
Sunk costs do not change regardless of which action is presently chosen. Students are repeatedly taught in economics classes that sunk costs are. The sunk cost fallacy can crop up inexplicably in day to day life. The sunk cost fallacy is convincing you that you cant give up because of all the time and money youve already spent. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project. A more detailed example aircraft research question. What is the opportunity cost of taking your freetrip for one. Whereas theoretical accounts and empirical examinations of the sunkcost effect have generally been based on the.
In spite of that, governments and corporations keep making that same mistake. The opportunity cost of investing in a healthcare intervention is best measured. Internet markets, delegating to it, sunk cost effect, economics of automated. A cost that does not vary across decision alternatives is called a sunk cost. This bidding mechanism gives manual bidders a seemingly competitive. They must monitor the costs in order to reach the optimum level of production. An example of obvious sunk costs can be found in the construction industry.
Or what if you have an outoftown boyfriend, and the only time you can get together is during the first week in december. Whereas theoretical accounts and empirical examinations of the sunkcost effect have. Sunk cost for the project is the sum total of equipment sunk cost, cost of equipment that cannot be salvaged and the cost of labor. In other words, its a cost that has already been paid and cant be refunded or reduced. Jun 06, 2018 christopher olivola psychological science, forthcoming abstract. The purpose of managerial economics is to provide economic terminology and reasoning for the. May 05, 2017 arkes and blumer used the example of an aircraft project. Since resources are scarce relative to needs,1 the use of resources in one way pre vents their use in other ways. With only exogenous sunk costs, expression 1 indi cates that the number of firms in equilibrium rises monotonically always with market size and market con centration falls. Different types of costs with examples from a to l. Sunk costs are costs that have already been incurred and cannot be recovered. This money is now gone and cannot be recovered, so it shouldnt figure into the businesss decision making process. A smart decision to take or not take the trip depends on opportunity cost, not money cost.
Oecd glossary of statistical terms sunk costs definition. This paper makes novel and significant contributions to research for several reasons. Sunk cost as a selfmanagement device 2 managementscience,articles in advance,pp. The sunk cost fallacy has also been dubbed the concorde fallacy examples of the concorde fallacy in the academic literature and beyond.
Sunk costs are past opportunity costs that are partially as salvage, if any or totally irretrievable and, therefore, should be considered irrelevant to. When sunk costs are high, a market will be less contestable but when sunk costs are insignificant, we are likely to see more firms competing because the barriers to entry are reduced. A typical example for sunk cost in the oil and gas industry is the cost that has been spent on drilling a well. The sunkcost fallacy has also been dubbed the concorde fallacy examples of the concorde fallacy in the academic literature and beyond. In these examples, the books, tattoos, letter drafts, and. Examples of sunk costs an example of obvious sunk costs can be found in the construction industry. The impact of delegating decision making to it on the sunk cost. This fallacy, which is related to loss aversion and status quo bias, can also be viewed as bias resulting from an ongoing commitment.
Sunk costs are always fixed costs, but not all fixed costs are sunk. A actual cost actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. Money spent on advertising, marketing and research and development projects which cannot be carried forward into another market or industry. A nonsunk cost is a cost that will only occur if a particular decision is. Examples of the impact of sunk costs on decisionmaking appear not only in. Sunk costs are costs that have already been incurred in the past and that nothing we do now or in the future can affect. A non sunk cost is a cost that will only occur if a particular decision is made. Whilst textbooks tend to concentrate on the costs of entering a market, often it is the financial implications of leaving an industry that act as one of the most. Managerial economics, objectives of the business firm, fundamental economic concepts, law of demand, demand elasticity, demand forecasting, consumer behaviour. A sunk cost is a cost that has already been incurred and cannot be recovered. Sunk costs, rationality, and acting for the sake of the past. Compare the new price of each object based on its make, model and serial number with the equipment to be replaced find the relizable salvage value of each product. Christopher olivola psychological science, forthcoming abstract.
Organization of the book l1 part i basic notions of costbenefit analysis 1 chapter one the context of project analysis 15 chapter two identifying relevant costs and benefits 19 transfer payments 19 contingencies 20 sunk costs 21 externalities and linkages 21 multiplier effects 23 international effects 23. Apr 27, 2020 in a certain sense, some sunk costs begin as variable costs. The lots and initial construction materials have been purchased, and framing has begun. It cannot be recovered or altered by future actions.