October 7th 2021

The Sunk cost Fallacy describes a tendency to follow through on endeavors where time, money, or effort has already been invested. The sunk cost fallacy was first introduced by behavioral scientist Richard Thaler, who suggested in 1980 that “paying for the right to use a good or service will increase the rate at which the good will be utilised.” Psychologists Catherine Blumer and Hal Arkes expanded Thaler’s definition beyond monetary investment, defining the sunk cost fallacy as “a greater tendency to continue an endeavour once an investment in money, effort, or time has been made.”

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Understanding the sunk cost fallacy

To test the fallacy in a real-world scenario, Blumer and Arkes conducted an experiment. They decided to sell discounted seasonal tickets at a theatre to determine if the amount of money spent on a ticket influenced the frequency with which people attended.

In the study, one group of attendees paid the full price of $15. Others were given a $2 discount, with a $7 discount given to a third group. The pair then recorded how many theatre shows each Individual attended. They found that individuals who paid full price for their tickets went to 4.11 shows on average. Those who received a $2 discount went to 3.32 shows, while attendees with the cheapest tickets went to 3.29 shows. Arkes and Blumer had clearly demonstrated the sunk cost fallacy in action. Attendees who paid full price for their tickets experienced the greatest sunk costs, meaning they were motivated to spend time at the theatre to recoup the higher price of the tickets.

Why does the sunk cost fallacy occur?

The sunk cost fallacy occurs because decision-making is often irrational and based on emotions. Indeed, failing to follow through on a decision can lead to feelings of guilt, remorse, or shame.

The fallacy is also related to commitment bias, or a tendency to remain committed to past behaviors despite those behaviors having undesirable outcomes. By failing to understand that the resources expended will never be recovered, the individual makes decisions based on past costs and not on more rational future costs and benefits.

Lastly, sunk cost fallacy may have some relationship with loss aversion. This is a cognitive bias suggesting that the pain of losing something is twice as powerful as the pleasure of gaining something. As a result, people are more likely to avoid losses than seek out gains. In the context of the sunk cost fallacy, the individual equates a loss with not following through on their decision.

How to avoid the sunk cost fallacy

Making rational decisions by ignoring the investment already made is the best way to avoid the sunk cost fallacy. This is a simple and effective solution on paper, but even the most logical people can be influenced by the fallacy when encountering it in real-world scenarios.

Research has also shown that simply knowing about the fallacy is not enough to avoid its influence. With that said, here are a few ways to avoid the psychological trap of sunk costs:

Omit the past in decision-making – decisions should be based on future costs and benefits by looking forward. Resist the urge to consider the cost of past actions in the decision-making process. In business, will pivoting on a project increase customer satisfaction scores? Will a move to the cloud enable the organization to scale and meet higher-level goals?
Reframe past costs – instead of considering past costs as a loss, think of them as costs that got the business to where it is today. A new tool that didn’t quite meet expectations could be reframed as a tool that supported the team until something better could be developed. A previous relationship that ended badly could be reframed as an important learning opportunity. This process is known as cognitive reframing, a psychological concept that may help the individual avoid making illogical decisions.
Use technology in decision-making – wherever possible, technology should be used to make decisions because it will not be swayed by the psychological satisfaction of sticking with sunk costs. For businesses, machine learning and predictive analytics encourage leadership to make forward-thinking decisions.

Key takeaways:

The sunk cost fallacy describes a tendency to follow through on endeavors where time, money, or effort has already been invested. It was first introduced by behavioral scientist Richard Thaler in 1980.
The sunk cost fallacy occurs because decision-making is often irrational and based on emotions. It is also closely associated with commitment bias and loss aversion, with the latter describing a tendency for individuals to avoid losses rather than pursue gains.
The sunk cost fallacy can be difficult to avoid for even the most logical thinkers. Cognitive reframing and the use of technology in decision-making are two strategies individuals and businesses can use to avoid it.

Connected Business Concepts

The straw man fallacy describes an argument that misrepresents an opponent’s stance to make rebuttal more convenient. The straw man fallacy is a type of informal logical fallacy, defined as a flaw in the structure of an argument that renders it invalid.

Gambler’s fallacy is a mistaken belief that past events influence future events. This fallacy can manifest in several ways. One example, if how individuals mistakenly conclude past events. Instead, to prevent the gambler’s fallacy, business people need to know that the real world is more complex and subtle than a game, and rather than relying on complex models, they can rely on solid time-proved heuristics.

The base rate fallacy occurs when an individual inaccurately judges the likelihood of a situation occurring by not considering all relevant data.

The Pygmalion effect is a psychological phenomenon where higher expectations lead to an increase in performance. The Pygmalion effect was defined by psychologist Robert Rosenthal, who described it as “the phenomenon whereby one person’s expectation for another person’s behavior comes to serve as a self-fulfilling prophecy.”

The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.

The bottom-dollar effect describes a tendency among consumers to dislike purchases that exhaust their remaining budget. If a consumer spends the last $50 in their bank account on dinner at a restaurant with friends, they may enjoy good food and good company. But after the meal, they feel dissatisfied because the meal has exhausted the last of their funds. Here, the negative emotions associated with running out of money have been applied to the meal itself. This is known as the bottom-dollar effect.

The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye-bye” before ordering, the average price per meal rose to $45.

In business, the butterfly effect describes the phenomenon where the simplest actions yield the largest rewards. The butterfly effect was coined by meteorologist Edward Lorenz in 1960 and as a result, it is most often associated with weather in pop culture. Lorenz noted that the small action of a butterfly fluttering its wings had the potential to cause progressively larger actions resulting in a typhoon.

The IKEA effect is a cognitive bias that describes consumers’ tendency to value something more if they have made it themselves. That is why brands often use the IKEA effect to have customizations for final products, as they help the consumer relate to it more and therefore appending to it more value.

The halo effect is a cognitive bias where the overall impression of a business, brand, or product influences how people feel and think about them. The halo effect was coined by psychologist Edward Thorndike in a 1920 study where military commanders were asked to rate subordinates based on several characteristics.

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