Sunk costs are simply costs that have already been incurred and cannot be recovered.
“A few years ago, my wife and I had booked a romantic weekend in Paris. But she was pregnant, and a couple of hours before we were due to catch the train she began feeling sick. She was throwing up into a plastic bag in the taxi on the way to the station. But when I met up with her, she was determined to go to Paris because our tickets weren’t refundable. She didn’t want to accept the loss and was about to compound it.
Being am economist is rarely an advantage in a romantic situation, but this was perhaps an exception. I tried to convince my wife to forget about the tickets. Imagine that the money we had spent on them had been lost for ever, I told her, but also imagine that we stood on the steps of Waterloo station with no plans for the weekend, when somebody came up to us and offered us free tickets to Paris. That was the correct way to think about the situation: the money was gone; and the question was whether we wanted to travel to Paris for no further cost. I asked my wife whether she would accept such an offer. Of course not. She was feeling far too sick to go to Paris. She forced a faint smile as she realised what i was telling her, and we went home.”
The Paris tickets were a sunk cost. The financial loss and already been incurred and could not be retrieved. Having spent the money Tim’s wife wanted to travel to Paris, even though she would have enjoyed the weekend far less than if she stayed.
Traditional microeconomics states that only future costs are relevant, and that people should not allow sunk costs to influence their decisions.
The more recent field of behavioural economics, however, acknowledges that people do not always act rationally. As such, decisions made in the present are often irrationally influenced by the sunk costs of the past.
The theory of loss aversion states that people tend to strongly prefer avoiding losses than acquiring gains. As such, following a loss people often make increasingly irrational decisions in the hope of recovering their losses, rather than treat it as a sunk cost and progressing rationally.
“While poker can be analysed rationally, with big egos and big money at stake it can also be a very emotional game. Poker players explained to me that there’s a particular moment at which players are extremely vulnerable to an emotional surge. It’s not when they’ve a huge pot or when they’ve drawn a fantastic hand. It’s when they’ve just lost a lot of money through bad luck (a ‘bad beat’) or bad strategy. The loss can nudge a player into going ‘on tilt’ – making overly aggressive bets in an effort to win back what he wrongly feels is still his money. The brain refuses to register that the money has gone. Acknowledging the loss and recalculating one’s strategy would be the right thing to do, but that is too painful. Instead, the player makes crazy bets to rectify what he unconsciously believes is a temporary situation. It isn’t the initial loss that does for him, but the stupid plays he makes in an effort to deny that the loss has happened. The great economic psychologists Daniel Kahneman and Amos Tversky summarised the behaviour in their classic analysis of the psychology of risk: ‘ a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.”