Hyper-Correcting for the Sunk-Cost Fallacy

Tuesday, June 23, 2009
By dreeves

sunk costs

Here’s a classic litmus test for the sunk cost fallacy:

You bought a ticket for a show.  The night arrives and you just don’t feel like going. Do you go anyway, so as not to have wasted the money on the ticket? Probably you shouldn’t. Your current decisions should not be influenced by money that is spent and unrecoverable.

There are, of course, some exceptions:

  1. Going to the show lets you avoid some painful cognitive dissonance — though this one doesn’t really accord with my notion of rationality.
  2. Going to the show preserves your reputation for making prudent choices (somewhat deceptively), and for following through on commitments.  Fair enough.
  3. You might not remember what all persuaded you to buy the ticket but the more you spent the better reasons you must have had.
  4. If you have a fixed budget for entertainment then the more you spent on the ticket the less you can afford alternative entertainment, increasing your value for the paid-for ticket.

But mostly those are rationalizations and, rationally, you shouldn’t go. The last one in particular is dangerous — what you need to consider is how much money you have left, not how much you spent on the ticket.

The lesson here is:  Don’t throw good money (or effort/energy) after bad.

 

Here’s another classic litmus test for the sunk cost fallacy:

Scenario 1: You bought a $10 non-refundable ticket to a show. (And note that you definitely would not have done so if the show cost $20.) As you get to the theater you realize you lost your ticket. Luckily, they have more available, still at $10. Do you buy another ticket?

Scenario 2: You didn’t buy a ticket ahead of time. As you get to the theater you realize that $10 has fallen out of your pocket and is lost. Luckily, you still have enough to buy a ticket. Do you do so?

Everyone agrees on Scenario 2. Of course you do. No one’s on such a tight budget that an unexpected change in wealth of $10 changes their utility for theater.

But many people refuse (I’ve checked) to see that Scenario 1 is fully equivalent.  They can’t bear to pay another $10 for a show they already paid $10 for. If Scenarios 1 and 2 don’t feel fully equivalent, you’re probably suffering from the sunk cost fallacy!

The lesson here is:  Do throw good money after bad.

 

The general lesson of the sunk cost fallacy is to not be influenced in either direction by money/effort that is spent and unrecoverable. In examples like the case of no longer feeling like going to the show, I will ask myself “would I go to see this show (or whatever) right now if it were free?”. I’ve actually seen people hyper-correct for the sunk cost fallacy. They might blow off a hundred dollar ticket because, given their current preferences, they’d only be willing to pay ten dollars for it! The point is to make your decision now as if the cost had never happened, hence “sunk cost”.

Quiz

To make sure you’re neither falling prey to the sunk cost fallacy nor hyper-correcting for it, here are some more sunk cost quiz questions. Feel free to leave your answers in the comments.  (When I floated this quiz among friends, family, and colleagues, only 8 of 19 people got them all right.  Those wrong on more than one included fancypants PhDs.)

Scene:  You have a non-refundable flight but now the opportunity to road trip with some friends to your destination has come up. Which of the following are rational and which are irrational:

  1. “I might do that much driving to save the flight costs but since the flight is paid for I’d rather take it.”
  2. “That flight was so expensive that I had to forgo another part of my vacation, so not using the flight is not really an option.”
  3. “I’m willing to blow off the flight if it was cheap enough.”
  4. “I’m going to drive because that’s what I would’ve done if I had considered the driving option in the first place; what’s happened since then is irrelevant.”
  5. “I’m going to fly because that’s what I would’ve done even if I had known about the driving option in the first place.”

And the last one has no right answer but I’ll throw it in anyway:

  1. “I need to use this flight otherwise I’ll be forced to admit to myself how dumb I was to book it too soon.”

ADDED: Here are the answers.

 

Illustration by Kelly Savage.

Tags: , , ,

  • http://www.cs.berkeley.edu/~kevin/ Kevin

    Interesting post. Here are my responses:
    1. rational
    2. irrational
    3. irrational
    4. irrational
    5. rational
    6. just plain silly

  • http://ai.eecs.umich.edu/people/dreeves dreeves

    @Kevin: I claim you are hyper-correcting! Stay tuned…

    EDIT: Oops! Speaking of hyper-correcting… Sorry about that!
    Here are my (your) answers.

  • http://partiallystapled.com/ gxti

    1. rational — If my only reason for road tripping is to save money, then doing so after already having purchased the ticket would not make sense as it would increase costs further. Therefore, taking the flight will minimize future costs.
    2. rational — If I couldn’t take the flight without pinching pennies, then I probably can’t afford to take the road trip as well. May vary depending on the nature of the costs.
    3. irrational — Like #2 I am thinking in terms of how much the ticket cost, however this time there is no implication that I cannot afford further expenses. Therefore it should have little bearing on my decision, and the rationalization fails.
    4. rational — Same scenario as #3 but coming from the other direction. If I can afford to blow off the ticket, and I want to, then I will.
    5. rational — The price never comes into play; even before the ticket was purchased the decision would have been the same.
    6. irrational — I may have lost less by buying the ticket sooner and discarding it than if I waited and paid a higher price closer to the date of the trip.

  • Mike S

    r, i, r, i, r, definitely r: I always book flights immediately before, and cost rarely appreciates

  • Kate

    It seems like there are a lot of variables, how long is drive? Who gets to control the radio? … I know that I am *far* from a rational consumer, but I’ll take a swing anyway:

    1. Rational – I view this as a choice between the flight (no additional cost) and the roadtrip (gas money, snacks, maybe hotel/camping)

    2. Rational – this situation seems to indicate that the budget is tight, so it seems like spending additional money to take the road trip would further stretch the tight travel budget

    3. Irrational

    4. Irrational – my thinking is that I might have driven since it would have (presumably) saved money. Now instead of saving money, driving would cost additional money, so what has happened since the decision was made does matter.

    5. Rational – since you would have flown even if you’d known about the road trip, knowing about the road trip shouldn’t change the decision (although I feel like this one might be a trick question) :)

    6. Rational :)

  • http://ctrl-c.us Caleb

    1. Rational — You may have been willing to drive to save the cost if you hadn’t paid, which is fine, but then you say that the flight is a sunk cost so the driving is essentially an avoidable cost.
    2. Way irrational — basically typical sunk cost fallacy
    3. Ambiguous. If the cost of the plane ticket is insignificant relative to disposable funds available for the trip, then this is irrational, and is similar to #2. However, if the plane ticket cost enough that now the choice to take the plane is decided by the desire to save the gas money + other road trip expenses, *but that wouldn’t have been the case had the ticket been a lot cheaper*, then this could be a rational statement.
    4. Irrational. The original decision would have been influenced by an expensive plane ticket, but now that is a sunk cost so the present decision should be made considering the ticket free.
    5. Rational. If you would have bought the ticket and taken the flight knowing the road trip was available, it’s certainly rational to take the flight after having sunk the money into the ticket.
    6. Ridiculous

  • required

    The flight is already paid for, so is essentially free as far as future action is concerned. The road trip will be with friends (a plus) but will take more time than the flight (perhaps a plus, perhaps a minus, thus a wash) and will cost money (a minus). Those are the only rational considerations I can come up with.

    With those in mind,

    (1) is rational based on the consideration that the road trip will cost money, but irrational if time with friends is valued more than the cost of the road trip.

    (2) is rational if my budget can’t stand the cost of the road trip even though I value time with my friends.

    (3) is irrational under all circumstances.

    (4)is irrational, mere mule-headed inability to go with the flow.

    (5) is rational. I clearly value a quick flight more than I value the cost to spend time with friends.

    (6) is rational if I value saving face over making rational considerations, and so is clearly irrational.

  • http://closetgeek.posterous.com/ klochner

    all right dreeves, I still think your wording is poor, with [1,4,5] the only obviously irrational/rational statements. You’re going to take issue with my resposne to (3).

    the relevant variables are:
    u(d) – utility of driving, including cost
    u(f) – utility of flying
    c(f) – cost of flying
    c(d) – cost of driving
    b – budget constraint

    Given that the flight is paid for, it’s rational to drive if:
    u(d) > u(f) and c(d)+c(f) < b and fly if: u(d) < u(f) or c(d)+c(f) > b.

    You could also consider a soft budget constraint, with the cost of the flight eliminating increasingly “good” alternative activities as the price goes up, and the cost of driving competing with those alternatives. I use the hard constraint below to simplify the logic.

    Keeping that in mind . . .

    1. “I might do that much driving to save the flight costs but since the flight is paid for I’d rather take it.”

    RATIONAL: it’s saying u(d) > u(f) – c(f) and u(d) < u(f), which is possible. 2. “That flight was so expensive that I had to forgo another part of my vacation, so not using the flight is not really an option.” RATIONAL (but semi-ambiguous) it’s rational if it’s saying c(f)+c(d) > b, which seems to be the implication by “had to forgo …”, but imho it’s poor wording: does “not really an option” mean “can’t afford to drive”? Why not just come out and say “I can’t afford to drive”?

    3. “I’m willing to blow off the flight if it was cheap enough.”

    RATIONAL (and more ambiguous) this is the inverse of (2), but the wording is more misleading: Can we assume “if it was cheap enough” to mean c(f)+c(d) < b? Or does “blow off the flight” somehow imply the budget constraint isn’t an issue? Surely the inverse of (2) is rational if (2) itself is rational. 4. “I’m going to drive because that’s what I would’ve done if I had considered the driving option in the first place; what’s happened since then is irrelevant.” IRRATIONAL: deciding based on u(d) > u(f)-c(f), which doesn’t imply u(d) > u(f).

    5. “I’m going to fly because that’s what I would’ve done even if I had known about the driving option in the first place.”

    RATIONAL, saying u(d) < u(f)-c(f), which implies u(d) < u(f)

  • keninsydney

    As a non-economist what I find interesting is that the reaction to “irrational” responses to the questions is to say that they are in some sense wrong.
    It’s as if a nineteenth century physicist who wasn’t blasted by x-rays when he opened an oven (this was a prediction of classical physics, the erroneous nature of which pointed the way to quantum theory) berated the oven.
    The problem is that the concept of rationality is short hand for “making the most money or obtaining the most goods’.
    Traditional economic concepts don’t capture some important aspects of human behaviour.
    I think Hersh Shefrin’s work on behavioural asset pricing is an indication of future ways forward.

  • http://www.mekiasmusictogether.com mdenby

    1. Rational, my lack of patience for long drives trumps my tiny fear of flying
    2. Rational,
    3. Irrational, I’m not at the point where blowing off money is an option
    4. Irrational, if I had planned on driving then why would I buy tickets? Rational, if money was not already spent so i guess my decisions are based on money.
    5. Rational
    6. Rational

  • http://stoneglasgow.blogspot.com Stone Glasgow

    In question number one, it is unclear if the speaker is taking the flight “because it is already paid for,” (sunk cost is important; I am taking the flight to avoid “wasting” money), or because “the flight is now effectively free, compared to a road trip, which is not free” (sunk cost is not relevant). I would suggest a rewording the question.

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