Is the Sunk Cost Fallacy Actually Smart Business?

Any student of economics knows this basic rule, which states that rational agents should not take irrecoverable or “sunk” costs into account when making decisions about present or future investments. Nevertheless, human beings break this rule all the time, succumbing to a cognitive bias known as the “sunk-cost fallacy.” If you have ever sat through a bad movie because you did not want to “waste” the money you paid for the ticket or finished a PhD program you lost interest in years ago because of all the work you had already done, you have made this mistake. But what if it were not always a mistake—what if, in certain situations, this “fallacy” were actually an optimal decision-making strategy?

Sunk Cost: Keep Calm and Carry On
That is the counterintuitive theory that Sandeep Baliga of the Kellogg Graduate School of Management and Jeffrey Ely of Northwestern University’s Department of Economics advance in their paper “Mnemonomics: The Sunk Cost Fallacy as Memory Kludge.” The authors argue that human beings—even rational ones—have a limited capacity to remember the original reasoning behind their decisions. If that capacity is exceeded, the information could be lost—so we need a mental placeholder that can remind us of why we decided something, just as tying a string around your finger reminds you that you need to pick up milk on the way home from work. This kind of ad hoc “memory device” is called a mnemonic. Mnemonic devices often encode some aspect of the relevant information as well, just as the letters in the mnemonic name “Roy G. Biv” stand for the first letters of the colors in the rainbow.

“It’s a shorthand way of remembering something that you might otherwise forget,” Baliga explains. “You look at it and you say, ‘Ah ha!’ Our theory about sunk costs is like that. You made a decision early on, and it cost you some money; later, you forget the details of why you made the decision, but you remember the cost. That’s the mnemonic.” The PhD student trudging ahead to complete his studies, for example, may not remember why getting a degree felt so important to begin with, but he does know that it has cost him thousands of dollars and years of effort so far. Therefore, it must make sense to complete the degree, because that “sunk cost” is a mnemonic device: it both reminds him of his original motivation and encodes some information about it. “He’d say, ‘It cost me this much time and money, so it must be important, and I’m going to carry on,’” Baliga says.

Inducing Forgetfulness for Fun and Profit
As economic theorists, Baliga and Ely could have laid out their intriguing argument (the title of their paper is a portmanteau of “mnemonic” and “economics”) and let their empiricist colleagues create models to test it. Instead, “we thought it would be fun to see ourselves if the theory held any water,” Baliga says. To simulate the experience of making decisions and then losing the memory of why they were made, Baliga and Ely devised a simple two-stage investment game. In the first, or initiation, stage, the player is presented with two numbers, each representing a possible value of a project to invest in. The game then presents the player with a numerical cost to initiate the project and asks if he wants to invest at that cost or pass. The second, or completion, stage shows the player the same information—the two possible value outcomes of the investment and the initiation cost that was already sunk in the previous round—along with a new number representing the cost to complete the project. The player can then choose to continue investing in the project or not.

But Baliga and Ely inserted a catch: each player had to repeat the initiation stage on twenty different projects before moving on to the completion stage. “When you come back to the completion stage on the first project, you’ve made so many other decisions on other projects that you’ve forgotten the specific reason why you chose to initiate it,” Baliga explains. “However, you can see exactly what you already spent.” After conducting their experiment on 100 first-year MBA students at the Kellogg School, the authors found that a significant number of them used their prior sunk costs as a mnemonic reminder of their initial investment strategy. If the sunk cost was low, they declined to complete the project; if it was high, they continued to invest. “As a player, you infer from the high initiation cost that the value of the project must have been really high—and so you figure it makes sense to keep paying in order to complete it,” Baliga says.

Prorated Fallacies
But the authors’ experiment also uncovered a novel effect of limited memory on economic decision making: a subtle variation on the sunk-cost fallacy that Baliga calls the “pro rata bias.” This bias is a similarly “irrational” tendency to figure sunk costs into current and future decisions, with the imagined goal of amortizing those past sunk costs with inflated variable costs in the present. “Let’s say you’re a pharmaceutical company who spends a lot of money on R&D,” Baliga explains. “Now let’s also say that a new drug discovered by that R&D process costs pennies to produce. That R&D money is gone and not coming back, but because of the pro rata bias, my students want to charge $5 per pill because of those sunk costs.”

Baliga and Ely were surprised to find that this pro rata bias appeared as a baseline effect in their experimental results—that is, even when the investment-game players were furnished with enough information during the completion stage to cancel out the limited-memory effects, the pro-rata bias persisted. To Baliga, this suggests that sunk-cost thinking may be “hardwired” into the human mind as a useful evolutionary adaptation. “We’re programmed by instinct—it’s like wanting to eat fatty food or meat whenever you see it,” he says. “We have to exert an enormous amount of self-control to avoid those tendencies. In the same way, even if memory were plentiful, we would still commit these sunk-cost fallacies.”

An Evolutionary Explanation?
So what of the fallacy itself? If it is a useful mental shortcut passed down to us by our savannah-dwelling ancestors, how can it also be “a mistake,” as Baliga calls it in no uncertain terms? “We call it the ‘theory of the second best,’” he says. “The more you can remember, the better it is, and you don’t have to commit this fallacy at all. But if it’s a common feature of human beings that they do forget stuff, then the sunk cost fallacy is an optimal response to that forgetfulness. Sunk costs can encode information about decisions you made in the past, and if that’s the case you should take them into account, because if you didn’t, you’d make even worse decisions.”

Meanwhile, what about corporations, with “memories” limited only by their employees’ prowess at record keeping? According to Baliga, companies and businesses follow sunk-cost biases as often as individuals do. So why would a company like IBM or Apple need the same mnemonic “kludge” against forgetting that a single fallible person does?

“The memory-limitation problem is actually bigger in organizations,” Baliga asserts. “Costs on a balance sheet are easy to keep track of. But strategic vision—‘why was this a good idea in the first place’—is not. As managerial turnover occurs, an organization forgets. You may inherit a previous CEO’s projects, but you can’t directly access his vision or strategic reasoning. What you can do is say, ‘The previous guy was smart, and I’m going to carry on because I can see what costs he sunk into it.”

Baliga cautions that the sunk-costs-as-mnemonic theory does not imply that every incoming CEO should blindly march ahead on whatever plans they inherit. Steve Jobs, for example, famously scrapped most of Apple’s then-current product lines when he retook the company reins in 1997 and led the organization to record profits. “In that situation, though, Jobs had clear evidence of what wasn’t working in the business, so he changed course,” Baliga explains. In contrast, he says, current Apple CEO Tim Cook is continuing on the path set by Jobs, even though he may not literally share the vision that started it all. “It’s up for interpretation, because that type of ‘soft information’ can never be fully recorded,” Baliga says. “Our research suggests that it may be prudent not to ignore the decisions made by your predecessors. They might encode things you don’t know, and may never know.”