Here is a question for you:
Every staff member in your company is given a free concert ticket. The seats are all in the middle of the front row. Each ticket is worth RMB300 but you get it free. Unfortunately, a blizzard comes on the very day, causing temporary suspension of transportation. Despite all these, the concert is going ahead as planned. If you really want to go for it, you have to walk for half an hour in this terrible weather. What will be your decision?
to go not to go
Now, suppose that the ticket is not given free of charge by the company, but is bought by yourself for RMB300, what will be your decision?
to go not to go
Most people won't go to the concert in the first case, for they don't count it as "waste of money". But in the second case, people will be reluctant to give up the ticket. Instead, they will choose to go in spite of the cold weather and lack of transportation. Your intuition will tell you that the ticket given freely by the company is an "extra gain" , which you won't feel too uncomfortable to lose. But the ticket which you queued in line for and spent money on is something you "cost" a great deal. That is why people make different decisions in different situations. What I am going to analyse further is the reason why people are more motivated to go to the concert when they pay the price for it.
Such a phenomenon is called "Sunk Cost Fallacy" in behavioural decision theory. In the decision-making process as to whether or not to take a certain action, one does not only take into account the costs and benefits one will encounter, but also the costs one has already incurred and cannot recover. The past irretrievable cost is called "Sunk Cost".
From a rational perspective, sunk cost should not play a part in our decision-making, because no matter whether you go to the concert or not, the money you paid is gone. As a rational decision maker, you should consider only expected future costs (e.g., the storm you have to suffer from) and benefits (e.g., the enjoyment of the concert). Whether or not you are going to the concert, the money has been spent. It should be counted as a constant and should be ignored in your decision making.
A friend of mine often wears a tie. Its colour is embarrassingly odd. I could not bear it and eventually told him that the tie was not suitable for him at all. His answer was astonishing. "Actually I feel the same as you do. But I have no choice. I spent over RMB500 on it. How can I leave it aside lying on the bottom of the drawer? What a waste would it be?"
This is quite a common phenomenon. When people are making a decision of purchase, they take into account many other factors than the expected utility value of the product. They might be lured by the promotion sale or even go for the simplest reason that they haven't bought anything after a whole day's shopping!
Behavioural decision research indicates that normal people are less than rational. When we say "Since we've bought this tie, we might as well wear it", or "Since we have bought the ticket, we might as well go for the concert", what we really mean is that we want to earn back the sunk cost by "keeping the course of action". But I would like to ask, "What is your purpose of buying a tie?" If the tie you bought does not fulfil your purpose, what will you gain? The ultimate gain is your happiness whereas merely wearing a tie or going to a concert is not a real gain. If wearing an unsuitable tie or going to the concert in a blizzard brings negative effects on you, you will not "take back" the cost already sunk. Instead, you will end up with getting into more troubles and wasting more money. RMB500 has been wasted in an ugly tie. Yet, we continue to wear it simply for the sake of money already "sunk". What a real "waste"! As to the concert, RMB300 has been paid for the ticket. But if we choose to go, we will have to struggle for a good hour in the freezing cold, which might totally spoil the happiness brought by the beautiful music and result in catching cold and being sick for several days. We are not against your wearing an unsuitable tie or going to a concert. The point we are trying to make is this: Do not let the sunk cost affect your rational decision. What needs to be taken into account is the costs and profits of an action itself, whereas the antecedent cost related to the action should be ignored.
GETTING STUCK DEEPER
You are the CEO of a pharmaceutical company and start a project of developing a new painkiller. Then you are recently informed that another pharmaceutical company has already developed a similar painkiller. If the project keeps going ahead, there will be a large chance of losing $5 million, with a small chance of gaining $25 million. It is in the beginning stage of the project and the company has not spent much yet. To put the product on the market will cost another $500,000. Will you continue the project or abort it?
to continue to abort
What will be your answer?
In this case, there is 10% chance of gaining $25 million and 90% of losing $5 million. Also, no substantial cost is made in the project. Should you continue or abort? Normally, people will choose to give up, which is quite reasonable.
But what about the following case?
You are the CEO of a pharmaceutical company and doing a project of developing a new painkiller. Then you are recently informed that another pharmaceutical company has already developed a similar painkiller. If the project keeps going ahead, there will a large chance of losing $5 million, with a small chance of gaining
$25 million. The project has been going on for quite a while and the company already has spent $5 million. To put the product on the market will cost the company another $500,000. Will you choose to continue or abort ?
to continue to abort
Except that you have spent $5 million in the project, the second case is exactly the same with the first one. Given my earlier explanation on "Sunk Cost Fallacy", you are expected to give the same answer as you do with the first one.
However, both in the States and in China, when I asked CEOs from various companies the above questions, most of them chose to abort the project in the first case, and continue the project in the second. They deem it worth all efforts to retrieve the cost, which is $5 million already cost. They don't seem to understand that for the sake of the sunk cost of $5 million, they risk 90% chance of wasting yet another $500,000 instead of taking back the past cost.
Therefore, be careful when you are making an investment: If you find it an erroneous decision, you should stop right at the point and turn back. Never add more mistakes to the error already made for the sunk cost. As a matter of fact, there are many cases where more investments are made in the hope that the sunk cost could be recovered and these decisions only lead to more losses. Many companies persist in continuing the project, in spite of the knowledge that there is no great prospect. The only reason for such a persistence is the mere fact that they have spent a large sum of money on it (sunk cost).
An error we often tend to make as consumers is that we choose to do something we are not willing to do just because money has been spent on it. The idea is that money spent on something can only be compensated for by genuine consumption. But you become even more irrational by continuing a wrong investment. The similar case of "adding more to the wrong investment" can be found in business world as well as in our daily life.
Nowadays, most parents expect their kids to have music talents and are able to play a musical instrument. It is a good way of cultivating the character and developing the intellectual potential. Lily's Mum is one of these parents. After consulting other people, she decided to buy a keyboard which cost her RMB2, 000. But despite Mum's enthusiasm, Lily was not keen on it. Lily would rather play outdoors with other kids after school till it was time for dinner. After dinner, she had to do homework. Little time was left for her to play keyboard. Although for the first few days, playing keyboard was a fresh experience for her, soon she lost the interest. She is a sporty girl, but not musical. Now when parents kept nagging her to play keyboard, she tended to become much more disobedient than ever. In the end, the keyboard was covered by a layer of dust. Then one day, a colleague of Lily's Mum told her about a piano teacher in the Academy of Music and recommended him to tutor Lily. Do you think it necessary to have a tutor for Lily at this point?
Lily's Mum discussed it with her husband. "The keyboard is ready for her. Why not make her keep learning? We might as well have a tutor to teach her. Otherwise, the keyboard will be wasted." Hence, they made the decision to invite the tutor and to pay him RMB500 for ten hours per month. Lily's interest in playing keyboard was gradually killed when she was forced to learn it. Leisure or a hobby, as it should be, now became an extra burden. Lily was more than reluctant. She made little effort and took every opportunity to escape the exercise. After half a year, her parents had to give up the "training project". They ended up with wasting the tuition fee of RMB3, 000, for they did not want to "waste" the keyboard!
Many people remain addicted to smoking despite the knowledge that smoking harms their health. In the same way, most people are addicted to "Sunk Cost Fallacy". It may mislead you to cost more than you should. In some more serious cases, it might result in catastrophe and bring about great loss of life and property.
Never be controlled by "sunk cost". Since it is of past tense and cannot be undone, we had better leave it aside. A helpful parable is that when you waste much time and have no way of getting it back, you had better not keep regretting it. At the very moment of your regretting, much more time slips away. Let us suppose we start from a new beginning and from now on, we only choose to do things benefiting us most.
BREAK EVEN OR SELL?
"Break Even" has always been a fundamental policy for most businessmen. It appears so natural and reasonable to say, "At least, we have to break even". Yet, this is a flawed concept. The idea itself involves "Sunk Cost Fallacy". Many retailers tend to refer to the wholesale price when setting the base line for the retail price. They will not sell with a price lower than what they have paid. This is not right. Suppose you are a computer retailer. You purchased 100 Pentium III at the unit price of RMB8, 000. Now these Pentium III are outdated. A school offers to buy them at the unit price of RMB4000. Will you accept the offer? Most retailers will not. If you are a rational decision-maker, you will not take into account the original price of RMB8, 000, for it is irrelevant to your present decision. What you should consider is whether or not you can sell those computers with a price higher than RMB4, 000. If the answer is "No", then RMB4, 000 is the best price you may get. Why not take the offer?
I still remember the story during my study in Yale. My parents bought a one-bedroom apartment at $72,000. When I graduated, the property price of New Haven (where Yale is located) was undergoing a drastic drop and the prospect of the market was bleak. Someone offered to buy our property at $58,000. I strongly advised that we accept the offer. But my parents decided that the bottom line of the property price should be $72,000, for they held to the idea of "breaking even". They rejected the offer. I obeyed their decision. But what was the result? We never found anyone who offered higher price than the one I mentioned above. We ended up with selling the property at $38,000.
SUMMARY
This article mainly discusses "Sunk Cost Fallacy". People normally want to retrieve what we call "sunk cost", which has been made and is impossible to be undone. And it leads to irrational behaviours. How can we correct such a fallacy? After you happen to make an irrational purchase, you should forget about it together with the "sunk cost" you have made. Take only into account the efforts you will have to make thereafter and the benefits entailed. Then, you can make an estimate as to whether or not some positive effects will be brought about. When making an investment, you need to look ahead and evaluate the whole situation. If you find out that it will not earn any profits, you really should give it up as early as possible. Never hold onto the cost already made, such as effort, time and money, etc.
"Sunk Cost Fallacy" can be found everywhere in our life, exerting negative influences, but sometimes functioning as check-and-balance. If we know how to play with it smartly, it will be able to serve us. In all the cases we discussed earlier, people are reluctant to give up an action rationally, for there is "sunk cost" involved. However, there are other cases where people give up something irrationally. Then, the sunk cost will help push you to act more rationally and become more purpose driven. Many people made "sunk cost" purposefully in order to control their own behaviours. In fact, it is a very effective way, for "Sunk Cost Fallacy" is indeed difficult to do away psychologically.
Here is a practical example. Many people make plans of physical exercise, such as doing aerobics three times a week in a gym. But most of them cannot stick to the original schedule, not because they do not put enough emphasis on the exercise, but because they have many other commitments including job, housework and entertaining friends. I suggest that you purposefully make a sunk cost so as to help you hold onto your original plan. You choose an expensive gym and pay a hefty non-refundable membership fee. Then you have the gym remind you every week how much you have paid and how little you have used. Thus, you will persuade yourself to go to the gym even when you are quite reluctant, for you have already paid! (Of course, the influence of the sunk cost will be diluted gradually as time goes by. So you'd better not pay a lump sum of five-year fee in advance, but rather pay monthly or twice a year.)
The following is another interesting example. A girl loves her boyfriend so much that she desires to have him forever. What should she do? One thing, among many others, is asking him to buy her expensive gifts frequently. Then, her boyfriend will become more and more reluctant to leave her, given the fact that he has already "cost" so much on her.
(Professor Christopher Hsee is Theodore O. Yntema Professor of Behavioural Sciences and Marketing in The University of Chicago Graduate School of Business, and Director of Centre of Behavioural Sciences at CEIBS. This article is adapted from his book Don't Be A Normal Fool, originally written in Chinese. The English version is prepared by Cherry Zhong.)
