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Sunk cost

In economics, sunk costs are costs that have already been incurred, and which cannot be recovered to any significant degree. For example, when you pre-order a movie ticket, the price of the ticket becomes a sunk cost; even if you later decide that you'd rather not go to the movie, the odds that you would be able to resell your ticket are essentially zero. Thus, there is no way to get back the money you originally paid, and you have a sunk cost on your hands.

Sometimes, only part of the price of a purchase ends up being a sunk cost. For example, when you purchase a car, you will be able to resell it later, though you will almost certainly not fetch the origional price for it. In this case, your sunk cost with respect to the car at any given time is the difference between how much you originally paid and how much you could sell it for now.

The idea of sunk costs is often employed in analyzing business decisions. An example of a sunk cost for a business is marketing, more specifically, promotion of a brand name. This incurs costs that cannot normally be recovered; it is not typically possible to later "demote" one's brand names in exchange for cash. (Of course, it is possible to sell a successful brand name to another firm. This is not very common, so for many analyses it may make sense to ignore this fact. If this possibility is entertained, then, again, the sunk cost is not the entire investment in promotion, but rather the difference between the investment and what the brand could later be sold for.)

Economists argue that, if you are rational, you will not take sunk costs into account when making decisions. In the case where you have bought a movie ticket and then realized that you really don't want to go to the movie, they would argue, you have two options: 1) pay the price of the ticket and suffer seing a movie you do not want to see, or 2) just pay the price of the ticket. The economist will suggest that since the latter option only involves you suffering in one way, while the former involves you suffering in two, the latter is obviously preferable.

On the other hand, if you regret buying the ticket because you do not think the movie is worth the money, then your current decision whether or not to go should be based on whether you want to see the movie at all, regardless of what you have paid for it, just like deciding whether you want to go to a free movie.

In contrast to this, many people have strong misgivings about "wasting" resources. Many people, for example, would feel obligated to go to the movie despite not really wanting to, because doing otherwise would be wasting the ticket price. Economists would probably label this behavior "irrational". Other people might label it "human".


Bibliography:

  • Varian, Hal R. Intermediate Microeconomics: A Modern Approach. Fifth edition. New York, 1999.



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